Tax Inefficiencies of ETFs for Canadian Investors

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Doug
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Tax Inefficiencies of ETFs for Canadian Investors

Post by Doug » 19 Dec 2011 20:26

I was interested in the new Vanguard Canada emerging markets ETF, so I emailed them about its taxation. The following is the response that I got:

"The US ETF (VWO), which (VEE) is wrap of, will pay a dividend to the Canadian ETF (VEE) net of foreign tax and net of US tax (at a witholding rate of 15%). The distributions paid by VEE will be decreased by foreign taxes and US taxes, but Canadian investors can receive a tax credit for the amount of the US withholiding tax."

I was interested in the taxation of iShares Canadian domiciled ETFs, so I sent them a similar email. The following is the response:

"Our wrapped products such as XEM, XSP, XIN and XWD are subjected to 15% US withholding taxes.

Investors in these ETFs will see a credit on their T3 tax slip on a annual basis. This is assuming that clients are holding these securities in a taxable investment account.

However, the only tax credit clients will receive are for the amounts withheld by the US, as the tax treaty is between Canada and the U.S. So even though funds such as XEM hold securities of other countries, the taxes that are withheld between the US and other countries is not claimable (no tax credit)."

Basically, the same answer as Vanguard. If you are investing in a Vanguard or iShares Canadian domiciled ETF that invests in foreign stocks other than those of the USA, the governments of those foreign countries will likely withhold tax on dividends. That tax is commonly 15%. If one assumes dividends of 2.5%, that means you lose 0.375% each year. So that 0.375% should be added to the MER.

So you decide that you'll buy the US ETF directly. I haven't emailed any ETF provider to find out about taxation. But I am very confident that what applies above also applies to the US ETF. In other words, one should add around an additional 0.375% to those US ETFs that invest in stocks outside the USA.

One irony is iShares XWD. About 5% of that fund is invested in Canada. Based on what iShares has written to me, you will get taxed twice on those Canadian dividends. And both times you get taxed, it will be as foreign dividends.

If TD can set up truly Canadian domiciled low cost index funds, why can't Vanguard and iShares set up truly Canadian domiciled ETFs? Both Vanguard and iShares emphasize their low fees. But the fact that one should add an additional 0.375% to the MER of many of their ETFs is a fact that they don't publicize.

I am becoming more cynical about the financial services industry. If Vanguard and iShares put the interests of Canadian investors first, why is there this hidden 0.375% added to the MER? Today, I also received a letter from CIBC stating that their MER rebate program was being altered. I would be surprised (shocked?) if this resulted in lower costs for me. If I want truly Canadian domiciled low cost index funds that aren't currency hedged, that leaves me with TD eseries. And TD shows how it feels about its eseries with the absence of enthusiasm in which it promotes them.

Index funds are supposed to be simple. Why aren't they for Canadian investors?

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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by AltaRed » 19 Dec 2011 21:10

Doug wrote:Index funds are supposed to be simple. Why aren't they for Canadian investors?
I suspect it is because the Cdn market in Toronto is too small to have the equivalent of ADRs traded there AND no ETF/index fund provider really wants to manage a truly Int'l ETF born, bred and operated out of Canada. With ~3% of the global market (and presumably investors) compared to ~40% for the USA, there is no money in it. One just has to live with the leakage as I am not about to buy 20 or more foreign stocks to emulate EAFE, or EA only, on my own. If you don't like that, don't invest outside US and Canada.
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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by Doug » 19 Dec 2011 21:17

If TD can do it with its eseries, why can't Vanguard and iShares? I think part of the answer is that Canadian investors aren't aware of this. If they were, it would hopefully be recognized as a problem that should be solved.

I surfed the web, and the present dividend yield that I got on the EAFE index is 3.51%. I couldn't find a dividend history on the EAFE index, but I found one on the S&P500 index. In 1981, the dividend yield on the S&P500 index was 5.57%. I would use that number of 5.57% as a maximum to which the EAFE dividend yield could go. The hidden addition to the MER would be 0.5265% and 0.8355% respectively.

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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by adrian2 » 19 Dec 2011 21:34

Doug wrote:If you are investing in a Vanguard or iShares Canadian domiciled ETF that invests in foreign stocks other than those of the USA, the governments of those foreign countries will likely withhold tax on dividends. That tax is commonly 15%. If one assumes dividends of 2.5%, that means you lose 0.375% each year. So that 0.375% should be added to the MER.
I was curious to check the validity of the "commonly 15%" number.

Here are the Foreign tax credit worksheets for eligible Vanguard funds:
- for VWO, it's 10.72%
- for EFA, it's 4.91%
you lose 0.375% each year
The loss (subject to the adjustments above) is actually before tax, so the number has to be multiplied by (1 - MTR).

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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by Doug » 19 Dec 2011 21:53

Adrian, thank you for pointing that out. If one assumes a 40% MTR, that means you lose 6.4% of the EAFE dividend and 2.95% of the Emerging Markets dividend. Compared to what one loses with currency hedging, the leakage from this is small. Perhaps my cynicism is unfounded.

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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by Doug » 20 Dec 2011 09:40

As mentioned previously, XWD is about 5% Canadian. The Canadian component of XWD is ISHARES MSCI CANADA INDEX FUND, which looks like it is a US domiciled fund. And the 2011 estimated distribution schedule of XWD is consistent with this. None of the distributions of XWD are eligible or ineligible dividends. It's all foreign income and return of capital. So the Canadian dividends in XWD are subject to a withholding tax by the CRA that's not recoverable; that tax might be 15%. Those dividends are then subject to a second tax as foreign income by the CRA. So if you're in at 45% marginal tax rate, you may be paying 61% tax on eligible dividends; in a tax efficient structure, you would pay perhaps 26%.

I think this is an issue that investors need to be aware of. What that in mind, I have posted this on another internet discussion board. Tax efficiency is an important part of investing. Over decades, small tax inefficiencies may no longer be small. Investors should be aware that there is an added hidden cost to some of Vanguard's and iShares' ETFs. This will allow an apples to apples comparison with other index funds, such as TD eseries, which I doubt are subject to this problem. Perhaps the added cost of creating truly Canadian domiciled ETFs would negate the greater tax efficiency, and so the present structures are in the best interests of Canadian investors. But I think it would be in the best interests of Canadian investors for them to be aware of the costs (including taxes) of the present quasi Canadian domiciled ETFs versus those of truly Canadian domiciled ETFs.

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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by AltaRed » 20 Dec 2011 10:11

Doug, while those leakages may be correct, and it is an interesting discussion, the ultimate test is the relative performance between ETFs of the same genre. If the performance difference is lost in rounding at the first or second decimal place, no one will care (whether that leakage is disclosed or not).

Disclosure: I own quite a bit of XWD because of my concern about US estate tax issues for US domiciled ETFs, and yes, I was quite aware of the leakage for the 5% Canadian component. But I looked at it as losing 15% of 2% of 5%, give or take a decimal point, of the overall holding, maybe 5 Starbucks a year. One needs to put it in perspective with overall returns, market volatility, The US tax roller coaster, etc.
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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by Doug » 20 Dec 2011 10:24

When I went to the link that Adrian provided on the foreign tax paid by Vanguard index ETF, the greater was the European Stock Index Fund at 10.9% and the least was the Pacific Stock Index Fund at 4.09%.

I agree that these hidden costs are small, but I think they shouldn't be hidden. Why waste free money?

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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by Doug » 21 Dec 2011 10:23

Thanks Adrian for pointing out another tax inefficiency of quasi-Canadian domiciled ETFs. The US ETFs, of which the quasi-Canadian domiciled ETFs are a wrap of, will receive income in the form of dividends, capital gains and return of capital. If these ETFs were truly Canadian domiciled, investors would be able to take advantage of the decreased tax on capital gains and return of capital. With these wrap structures, the distributions of the quasi-Canadian domiciled ETFs will be taxed as foreign income at one's marginal tax rate. This would also apply to distributions from US domiciled ETFs that Canadian investors receive.

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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by Doug » 22 Dec 2011 18:53

When I went through the TD eseries thread, I was reminded of a tax inefficiency of truly Canadian domiciled funds that invest in foreign stocks and are held in a tax advantaged account.

The governments of foreign countries will very likely impose withholding taxes on dividends of those foreign stocks. Outside tax advantaged accounts, you may be able to get tax credits for those withholding taxes. Inside your tax advantaged accounts, you won't. However, in an RRSP, US domiciled ETFs that invest in US stocks will not have any withholding taxes imposed by the IRS.

My guess is that the quasi Canadian wrap funds will have the same tax inefficiency as truly Canadian domiciled funds.

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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by adrian2 » 23 Dec 2011 08:54

Doug wrote:My guess is that the quasi Canadian wrap funds will have the same tax inefficiency as truly Canadian domiciled funds.
"Quasi Canadian wrap funds" will be worse than truly Canadian domiciled funds when held in a non-registered account.

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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by Penquin007 » 12 Apr 2012 18:01

After reading this thread, it is not clear to me what is the most tax effective option for foreign equities inside taxable accounts:

- Canadian domiciled mutual funds like TD e series (but usually ETF are supposed to be more tax effective than mutual funds..)
or
- Quasi Canadian wrap funds like XWD

?

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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by Penquin007 » 21 Apr 2012 09:27

I found a new article written by Dimensional fund advisors that explains quite nicely the withholding tax problem with foreign ETFs, it's a "must read" for any investor with US listed ETFs!
Attachments
Foreign_Withholding_Taxes.pdf
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Last edited by Penquin007 on 21 Apr 2012 12:57, edited 1 time in total.

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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by AltaRed » 21 Apr 2012 11:05

That is a good article that simplifies the discussion with nice flowcharts. Thank you for that. There are other threads in this forum where this issue has been discussed before. It is a problem with US ETFs investing overseas, like VGK (Vanguard Europe), or even iShares Canada XWD (which is a wrap of US ETFs including non-North American components).

That said, the effect of the answer may not be much (if any) in a taxable account if the Cdn domiciled ETF has an MER difference that offsets this effect. Example: If a Cdn domiciled ETF (of European stocks) has a MER or 50 basis points and the equivalent US domiciled ETF (or European stocks) has a MER of 20 basis points (delta of 30 basis points), and the underlying basket of European stocks has a dividend yield of 3% (and a foreign withholding tax rate of 15%... which is 15% of 3% = 45 basis points), the leakage is only 45-30 = 15 basis points. There are likely scenarios where it is 'worth' having the US domiciled equivalent (or a wrap). FWIW, I own XWD (a wrap) knowing there is leakage, but I do it to avoid ever changing risks of US Estate Tax issues.
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Re: Tax Inefficiencies of ETFs for Canadian Investors

Post by Penquin007 » 21 Apr 2012 12:47

Another potential tax drag with US listed ETF is the loss of capital gain distributions’s preferred tax treatment, which will be taxed as regular income if you use a US-listed ETF.

Here is an interesting article on the subject by Jamie Golombek:

Taxing Foreign Dividends
http://www.advisor.ca/tax/tax-news/taxi ... dends-2459

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