Every Canadian investor needs a few good foreign stocks and a tax-free savings account (TFSA).

PORTFOLIO MAKEOVER

A TFSA is, in my opinion, the best way for Canadians to save money and avoid tax on the profits their savings produce.

The question for many investors is whether these two investment possibilities belong together.

Financial advisers counsel investors to avoid holding dividend-paying foreign stocks in a TFSA (or an RESP) due to the non-resident withholding tax levied by many governments. This tax, which is collected before dividends are paid to non-residents, is not recoverable, effectively reducing the return rate. The usual destination for foreign stocks is an RRSP where the dividends are frequently tax-exempt.

As TFSAs grow in size, it has become more difficult to ignore the diversification and profit opportunities of dividend-paying foreign stocks.

One way to avoid this withholding tax but still get foreign stock diversification in a TFSA is to buy non-dividend-paying foreign stocks. You lose the steady dividend income stream, but you should profit from capital gains. Warren Buffett’s Berkshire Hathaway is a great example of a quality foreign stock with a stated policy of not paying dividends. The B shares, which trade in the $100 range, are the class to buy; the A shares currently trade at more than $156,000 each. Particular care is needed when choosing non-dividend-paying stocks as these equities tend to be higher-risk growth stocks, and in a TFSA, capital losses cannot be used to offset any capital gains.

For those intent on buying dividend-paying foreign stocks for their TFSAs, Jamie Golombek, managing director, tax and estate planning at CIBC Private Wealth Management, warns that the whole area of foreign dividend-withholding taxes is extremely complicated.

The withholding tax rate and any exemptions available depend on the tax treaty that Canada has signed with the country where the company issuing the stock is located. For stocks from some countries, investors may be able to reduce the tax on dividends by completing some paperwork. For example, the standard dividend withholding tax rate for U.S. stocks, the most popular foreign stocks held by Canadians, is 30 per cent, but if you file a U.S. Internal Revenue Service Form W-8BEN with your broker, the rate is lowered to 15 per cent.

For instance, the annual dividend paid on 1,000 shares of General Electric is currently $760, but if you own these shares in your TFSA, and had filed the above form, you would receive only $646 in dividends. The difference, $114, is lost to withholding tax.

European countries tend to levy their full statutory withholding rate on dividends paid to non-residents. If the actual rate specified in the tax treaty with Canada is lower, an administrative process must be followed to reclaim the overpayment amount.

The bottom line is that Canadian investors usually end up paying a 15 per cent withholding tax on most dividends issued by foreign stocks held in a TFSA.

“Paying any tax defeats the purpose of a TFSA,” Mr. Golombek says. “We recommend that clients hold dividend-paying foreign stocks, whether directly as an American Depositary Receipt or through funds, in accounts other than a TFSA.”

Horizons S&P 500 Index (C$ Hedged) ETF, HXS-T, offers Canadians a unique approach to investing in dividend-paying foreign stocks. HXS seeks to replicate the performance of the S&P 500 Canadian Dollar Hedged Total Return Index. This well-known stock market index includes a diverse mix of 500 large, U.S. publicly traded companies, both dividend and non-dividend payers, and is considered a proxy for the U.S. equities market. In reality, the Index provides broad international exposure as the member companies derive a significant portion of their sales (46.1 per cent in 2011) from outside the United States.

HXS is a synthetic ETF that does not actually own the shares in its target index. Rather, it uses a total return swap methodology to replicate the performance of the index. Money from the sale of HXS units goes into a cash account held in safekeeping by custodian financial institutions. Horizons has contracted with the National Bank to swap the specified total return of the ETF units (i.e. the capital gains/losses plus dividends earned by the target index) for a negotiated payment. The interest from the cash account and a swap fee of 0.30 per cent of the ETF’s net asset value finance this payment. The swap fee is on top of a MER of 0.15 per cent.

Because HXS owns no shares, it does not issue or receive any cash distributions and is not subject to U.S. taxes, including dividend withholding tax. There are no trading costs or tracking error and the value of any distributions is reflected immediately in the net asset value of the ETF.

Given the efficiencies of the swap structure, HXS tracks its underlying index more precisely than traditional ETFs such as the iShares S&P 500 Index Fund (CAD-Hedged), XSP-T, which tracks the same index. To wit, as of Feb. 28, 2013 over one year, the return rate (after fees) was 13.46 per cent for HXS, 13.18 per cent for XSP, and the Index itself returned 13.92 per cent.

Since inception, HXS has used financial derivatives to eliminate the impact of the U.S./Canada currency exchange rate on returns. The cost of this hedge creates index tracking error. As of April 1, Horizons has eliminated this error by removing the U.S. currency hedge from HXS.

According to Horizons Exchange Traded Funds Inc. swap-based ETFs do not exist in the United States and his firm is the only Canadian swap-based ETF provider. For the average Canadian investor, HXS is likely the only practical way to gain exposure to dividend-paying foreign stocks in a TFSA without the drag of foreign dividend withholding tax.

Gail Bebee is Canada’s independent voice on personal finance and author of No Hype –The Straight Goods on Investing Your Money, a popular book of investing basics for Canadians from a financial industry outsider viewpoint. Through her writing, speaking and teaching, Gail shows people how to take control of their money and achieve their financial goals. Her column will appear monthly on the Financial Road Map site. Her website is www.gailbebee.com