US Withholding Tax for Canadian Registered Charitable Foundations
Many Canadian charitable foundations hold US stocks in their investment portfolio. However, it’s essential to understand the application of US withholding tax for Canadian registered charitable foundations in the context of the US-Canada tax treaty to minimize exposure to this tax. And as this post will explain, there’s a common mistake many foundations make when structuring their investments that exposes them to US dividend withholding tax (and many don’t even know it!).
Withholding Tax Basics
Withholding tax is a tax levied on income earned by non-US residents from US sources, including dividends paid on US stocks. This withholding tax rate is 15%. For example, if a Canadian based investor receives $100 of US source dividends, $15 will be withheld by the IRS. However, under the US-Canada tax treaty, Canadian registered charities are exempt from this tax. But unfortunately, many Canadian charitable foundations are still paying this tax, why?
US Withholding Tax for Canadian Foundations
If foundations hold US stocks directly, and file a W-8BEN-E, they will avoid US withholding tax. But, when Canadian foundations hold their US stocks inside a Canadian based pooled fund, they inadvertently pay US withholding tax . Since such a fund is domiciled in Canada, the fund itself will be subject to US dividend withholding tax, even though some of the fund’s ultimate owners may be Canadian registered charitable foundations who should be exempt from this tax.
In other words, if a Canadian charitable foundation holds units of an investment fund based in Canada that in turn holds US dividend-paying stocks, the dividends received by the fund will be subject to US withholding taxes.
The best way for foundations to avoid the US withholding tax pitfall is to hold US stocks directly (plus file an W-8BEN-E with their broker) instead of using pooled funds.
Investing Directly in US Stocks
Considering the hidden costs of using pooled funds, the best option for Canadian charitable foundations is to hold their US stocks directly and file a W-8BEN-E. And, they should also avoid using Canadian based pooled funds that hold US stocks. Foundations who use portfolio managers to choose their stocks need to be careful to ensure these stocks are held directly, and not through pooled funds.
Investing in Pooled Funds
Many Canadian charitable foundations use mutual funds and ETFs to invest in US stocks. This is a common mistake. Because, if the fund is domiciled in Canada, it will be subject to the US withholding tax on the dividends the fund receives. Regardless of whether the ultimate owner is a Canadian registered charity.
The consequences for Canadian foundations holding US stocks inside pooled funds are severe. Especially considering the withholding taxes paid could be directed to the charitable mission instead. In fact, trustees and directors of charitable foundations have a duty to guard against paying this tax.
How Much Does a Withholding Tax Mistake Cost?
Consider a charitable foundation with a $50 million portfolio. 30% is allocated to a US equity fund domiciled in Canada. The dividend yield of this fund is 2%. Its possible the charity is giving up $45,000 per year worth of withholding tax.
The worst part of this whole topic may be that many Canadian charitable foundations don’t even realize they are paying US withholding taxes. And the foundation may be making the mistake over many years without noticing. Since, the tax is being paid by the pooled fund, and not be the charitable foundation directly. It means, the taxes being paid don’t show up in the foundation’s own accounting. The tax is hiding behind the curtain of the pooled fund.
Complimentary Review
Our family office works with Canadian charitable foundations by providing them with foundation administrative and management services. Private foundations can outsource their entire management to our firm.
We’ve found tax mistakes costing hundreds of thousands of dollars (annually). So, contact us to arrange a complimentary review of your foundation’s investment portfolio to determine whether you’ve been exposed to US withholding tax.
There are also ways to claw back this tax. We work with cross border tax lawyers and accountants who can potentially help you get a refund for previous year’s taxes paid inadvertently. Contact US for more details.