Impact of US Withholding Taxes for Canadian Investors

Withholding taxes are deducted at source before income is paid to an investor. In the context of Canadian investors with US stocks, withholding taxes refer to the taxes that are deducted by the US government on dividends paid to Canadian residents.

But, the US withholding tax rules can be a bit complicated, so this post provides an overview of the key considerations for Canadian investors including the rules relating to ETFs.

Withholding Tax Basics

If a Canadian resident holds a US stock that pays a dividend, the US government will typically withhold 15% of the dividend amount as a withholding tax. The remaining 85% of the dividend amount will be paid to the Canadian investor.

The purpose of withholding taxes is to ensure that non-US residents pay taxes on income earned from US sources, even if they are not subject to US income tax.

Special Rules for Canadians

For Canadian investors holding US stocks, there is a tax treaty between our two countries that enables Canadians to use certain exceptions.

Canadian investors can think about the tax treaty this way: when there is an equivalent tax situation for US residents, usually Canadians will share similar rules. But, when differences between the two countries exist, Canadians won’t receive those special benefits.

This is most noticeable when it comes to registered accounts. Especially TFSAs.

For Canadian investors, US withholding taxes should be considered carefully when choosing where to hold investments. Canadian investors receiving US interest income may not typically be subject to withholding taxes, but Canadian investors holding US dividend paying stocks certainly will.

The matter is complicated even more by the fact that investors who use registered accounts (like RSPs, TFSAs, and RESPs) and those using holding companies and using charitable foundations add even more complexity.

Do Canadian investors pay withholding tax from US ETFs?

One of the most popular investing trends of our generation is the rise of passive investing. But, using index funds & ETFs means that Canadian investors need to be thoughtful about where & how they hold these investments. Otherwise, they could forfeit some tax benefits or incur additional tax costs (like double taxation).

Sometimes Canadian investors will be subject to withholding tax from their US ETF investments. But, its important to make a distinction between the location of each of your ETF holdings for tax purposes to make a fair determination.

ETFs and withholding taxes

ETFs based in Canada that hold US dividend paying stocks will be subject to the withholding tax at source. Canadian investors holding these funds will receive the net proceeds of the dividends (net of the withholding tax already taken).

This isn’t a problem for most wealthy Canadian individual investors. Since, your individual tax rate will be higher than the withholding amount. And, Canadian resident individual investors receive credit for the foreign taxes paid under the treaty.

But, there may be problems for Canadian investors who hold certain ETFs in their registered accounts.

Canadian investors holding US based ETFs

Don’t hold US dividend paying stocks or ETFs holding US dividend paying stocks in your TFSA. This is because there is no treaty benefit for TFSAs that is recognized. So, Canadian investors holding US stocks or ETFs holding US dividend paying stocks will still be subject to US withholding taxes on those dividends.

Also, Canadian investors should make sure to avoid holding ETFs based in Canada that own US dividend paying stocks inside their RSPs. Since, the Canadian based ETF holding US dividend paying stocks will automatically be subject to withholding tax and doesn’t consider where end user investors hold their units.

Which ETFs should Canadian investors hold in their registered accounts?

Canadian investors should hold Canadian stocks and other fixed income investments (bonds, GICs, etc) inside their TFSA, and avoid holding US dividend paying stocks or funds/ETFs holding US dividend paying stocks inside their TFSA.

When ETFs or investment funds are held by Canadian investors inside their RSP/RIF, they could include holdings of US stocks. But, to avoid forfeiting the tax benefit of no tax on income inside an RSP/RIF, ensure US stocks held inside an RSP/RIF are either held directly or within funds located in the US. For example, hold units of a fund/ETF that is based in the US in RSP/RIFs, not based in Canada. This is because the US recognizes RSP/RIFs in the tax treaty.

What are the Estate Tax considerations?

Many Canadian investors with potentially large estates hold their US stocks using ETFs based in Canada or by holding US stocks directly inside a Canadian based corporation. Both these strategies may help Canadian investors with large estates avoid getting tied up in US estate taxes.

The result is that these investors will be subject to withholding tax on the dividends they receive from their US stocks.

Its important to consider the ways that withholding taxes will be applied to your investments because it will inform your strategy on where to hold these investments and which investment vehicles to use.