• Asset Location Across Canada

Asset Location Across Canada: Some Rules Are Made To Be Broken

Aren’t GPS devices the best thing ever? You punch in your desired destination and they tell you exactly where to go. Then again, every so often, they’ll go wonky on you, insisting you turn on a street that doesn’t even exist, or sending you straight into a major traffic jam.

Just so with implementing asset location, as introduced in my last post. General guidelines can be useful when trying to understand complicated topics like tax-efficient investing. In practice, however, these rules of thumb can lead you astray – especially if you follow them blindly, without regard to what’s going on right around you.

For example, you’ll often hear that it’s wise to fill up your taxable accounts with Canadian equities first and global equities next. Sometimes, this makes sense, as the Canadian company dividends receive preferential tax treatment (and global stock dividends don’t).

But where do you live? Depending on your actual tax rate and which province or territory you call home, there may be times when this “Canada first” rule of thumb might be a thumbs-down idea for you.

Today, I’ll explain how to estimate the taxable dividends on the equity ETFs in my model portfolios. We’ll then review the taxes payable in 2016 on each of the ETFs for residents across Canada. I’ll wrap up with suggested taxable account asset locations for top-rate taxpayers in each jurisdiction.

By the way, all yields and MERs below are annual; I’ll skip repeating that every time!

Canadian Equities

The Vanguard FTSE Canada All Cap Index ETF (VCN) follows the FTSE Canada All Cap Index, which has a gross dividend yield of 2.88%. Once we deduct the fund’s MER of 0.06%, we end up with a taxable dividend yield of 2.82%. Although this may seem high relative to the other asset classes below, you’ll recall that the eligible dividends receive preferable tax treatment, resulting in lower taxes than if the dividends were treated as ordinary income.

So … remember that rule of thumb, suggesting higher-income earners should first hold Canadian equities in their taxable accounts before all other asset classes? This really only applies in jurisdictions with relatively low eligible dividend tax rates (generally below 35%). Otherwise, you may be better off first holding certain foreign equities in your taxable accounts, even though their dividends are fully taxable as income.

Source: FTSE Russell Index Fact Sheet as of July 31, 2017

 

U.S. Equities

The iShares Core S&P U.S. Total Market Index ETF (XUU) follows the S&P Total Market Index, which has a measly gross dividend yield of only 1.90%. After deducting the fund’s expenses of 0.07%, the taxable dividend yield drops to about 1.83%. Even though taxes are initially withheld on the foreign dividends, they are generally recoverable at tax time, when you will be fully taxed on the dividends after the fund’s expenses have been deducted.

For provinces or territories with relatively high eligible dividend tax rates (i.e. above 35%), U.S. equities may be a more tax-efficient first choice to hold in your taxable accounts, instead of the Canadian-first rule of thumb.

Source: S&P Dow Jones Index Fact Sheet as of July 31, 2017

 

International Equities

The iShares Core MSCI EAFE IMI Index ETF (XEF) follows the MSCI EAFE IMI Index, which boasts an impressive dividend yield of 2.96%. As XEF holds the underlying stocks directly, any foreign withholding taxes are generally recoverable at tax time. Similar to U.S. equities, investors will be fully taxed on the gross dividends after deducting the product fees of 0.22%, for a taxable dividend yield of about 2.74%.

Although many investors love their dividends, this spells trouble for taxable investors throughout Canada. As I mentioned in my last blog post, if you’re going to hold any equities in your RRSP accounts, international equities should be your first choice (and your last choice for taxable accounts). This is one rule of thumb that applies nationwide, since there is not a single province or territory where holding international equities in taxable accounts first is expected to reduce the tax bill.

Source: MSCI Index Fact Sheet as of July 31, 2017

 

Emerging Markets Equities

The iShares Core MSCI Emerging Markets IMI Index ETF (XEC) follows the MSCI Emerging Markets IMI Index. With a gross dividend yield of 2.32%, it falls somewhere between U.S. and international equities.

As XEC doesn’t hold the underlying stocks directly, there’s one layer of unrecoverable foreign withholding taxes, with an estimated tax drag of 0.23%.

With fees of 0.26%, it’s also the most expensive ETF in my model portfolios. After deducting the fees and foreign withholding taxes, we end up with a taxable dividend yield of about 1.83% (which happens to be identical to the U.S. equity taxable dividend yield). This low yield may make emerging market equities even more tax-efficient than Canadian equities in many jurisdictions going forward (including Ontario, Manitoba, Quebec and Nunavut).

Source: MSCI Index Fact Sheet as of July 31, 2017

 

Our Model Portfolio Summary

So, in summary, below is the expected taxable dividend yields on the ETFs in my model portfolios. (Remember, VCN’s dividend yield is taxed at the lower eligible dividend tax rate, while the remaining ETFs are taxed at ordinary income tax rates.)

Expected Taxable ETF Dividend Yields

Exchange-Traded FundGross Dividend YieldUnrecoverable Foreign Withholding TaxManagement Expense Ratio (MER)Taxable Dividend Yield
Vanguard FTSE Canada All Cap Index ETF (VCN)2.88%-(0.06%)2.82%
iShares Core S&P U.S. Total Market Index ETF (XUU)1.90%-(0.07%)1.83%
iShares Core MSCI EAFE IMI Index ETF (XEF)2.96%-(0.22%)2.74%
iShares Core MSCI Emerging Markets IMI Index ETF (XEC)2.32%(0.23%)(0.26%)1.83%

Sources: FTSE Russell, S&P Dow Jones and MSCI Index Fact Sheets as of July 31, 2017. BlackRock Canada and Vanguard Canada.

 

Going Local

Now, to the good stuff. What are the optimal asset location guidelines where you live?

For that, let’s estimate which asset class has the lowest expected annual tax liability in each province or territory by calculating 2016 taxes payable on a $10,000 investment for a taxpayer in the highest marginal tax bracket.

To make the comparison a little easier on the eyes, I’ve included a second chart below that provides the optimal 2016 asset location order for taxable accounts. (I’ve only considered annual income and its tax ramifications here, since we cannot accurately predict your unique long-term, unrealized gains.)

The compelling conclusions?

  • Most of the provinces and territories with the lowest eligible dividend tax rates tend to favour Canadian equities first (except Nunavut, which has relatively low ordinary income and low eligible dividend tax rates)
  • Jurisdictions with the highest eligible dividend tax rates favour U.S. equities first.
  • Throughout Canada, international equities place dead last in terms of tax-efficiency (due to the relatively high taxable dividend yield).
  • Going forward, emerging markets may swap places with Canadian equities in Manitoba, Nunavut, Ontario and Quebec.

2016 taxes payable on a $10,000 investment (top marginal tax bracket)

Province or TerritoryVanguard FTSE Canada All Cap Index ETF (VCN)iShares Core S&P U.S. Total Market Index ETF (XUU)iShares Core MSCI EAFE IMI Index ETF (XEF)iShares Core MSCI Emerging Markets IMI Index ETF (XEC)
Alberta$88$93$131$101
British Columbia$87$92$130$100
New Brunswick$95$103$145$112
Northwest Territories$79$91$128$99
Prince Edward Island$95$99$140$108
Saskatchewan$84$93$131$101
Yukon$69$93$131$101
Manitoba$105$97$138$106
Nunavut$92$86$121$93
Ontario$109$103$146$112
Quebec$111$103$145$112
Newfoundland and Labrador$113$96$136$105
Nova Scotia$116$104$147$113

Sources: 2016 Personal TaxPrep, TaxTips.ca, CDS Innovations Tax Breakdown Service, BlackRock Canada, Vanguard Canada

2016 Asset Location Order for Taxable Accounts

Province or TerritoryOrdinary income (top marginal tax rate)Eligible dividends (top marginal tax rate)1st2nd3rd4th
Alberta48.00%31.71%Canadian EquitiesU.S. EquitiesEmerging Markets EquitiesInternational Equities
British Columbia47.70%31.30%Canadian EquitiesU.S. EquitiesEmerging Markets EquitiesInternational Equities
New Brunswick53.30%34.20%Canadian EquitiesU.S. EquitiesEmerging Markets EquitiesInternational Equities
Northwest Territories47.05%28.33%Canadian EquitiesU.S. EquitiesEmerging Markets EquitiesInternational Equities
Prince Edward Island51.37%34.22%Canadian EquitiesU.S. EquitiesEmerging Markets EquitiesInternational Equities
Saskatchewan48.00%30.33%Canadian EquitiesU.S. EquitiesEmerging Markets EquitiesInternational Equities
Yukon48.00%24.81%Canadian EquitiesU.S. EquitiesEmerging Markets EquitiesInternational Equities
Manitoba50.40%37.78%U.S. EquitiesCanadian EquitiesEmerging Markets EquitiesInternational Equities
Nunavut44.50%33.08%U.S. EquitiesCanadian EquitiesEmerging Markets EquitiesInternational Equities
Ontario53.53%39.34%U.S. EquitiesCanadian EquitiesEmerging Markets EquitiesInternational Equities
Quebec53.31%39.83%U.S. EquitiesCanadian EquitiesEmerging Markets EquitiesInternational Equities
Newfoundland and Labrador49.80%40.54%U.S. EquitiesEmerging Markets EquitiesCanadian EquitiesInternational Equities
Nova Scotia54.00%41.58%U.S. EquitiesEmerging Markets EquitiesCanadian EquitiesInternational Equities

Sources: 2016 Personal TaxPrep, TaxTips.ca, CDS Innovations Tax Breakdown Service, BlackRock Canada, Vanguard Canada

 

So, there you have it: A few jurisdiction-specific rules of thumb to guide you along your tax-wise way. But, as with that GPS that usually takes you where you want go, you may want to take a good look around at your personal circumstances before blindly following anyone’s general directions – even mine.

By | 2017-08-28T13:04:01+00:00 August 28th, 2017|Categories: Investment Taxation|17 Comments

17 Comments

  1. Kevin September 19, 2017 at 2:51 pm - Reply

    Hi Justin,

    Love you blog. Can you do an article on order of withdrawal between RRSP, TFSA, and Taxable in retirement. there are a few online but they are very general.

    Thanks
    Kevin

    • Justin September 19, 2017 at 3:04 pm - Reply

      @Kevin: Thanks for the feedback! That does sound like an interesting topic – I’ll see what I can put together in a future blog post.

  2. Chrissy September 4, 2017 at 3:13 pm - Reply

    Love this post Justin. Helps confirm everything that you and Dan have always taught, but with even more detail. What would Canadian investors do without you two?! Keep up the great work. It’s needed and very much appreciated.

    • Justin September 4, 2017 at 5:11 pm - Reply

      @Chrissy: I’m so glad you’ve enjoyed reading our work – there’s many more articles in the works 🙂

  3. Chuck September 3, 2017 at 10:56 pm - Reply

    Hi Justin,

    As a resident of Ontario who has maxed out my tfsa and rrsp contribution room, I have trouble accepting the idea that booting U.S. equities from my tax advantaged accounts is ultimately a fiscally responsible thing to do.

    I want my tfsa and rrsp to grow to be as big as possible so that when I retire (or need to make a big purchase) I can draw as much tax free/deferred money as possible. Taking my American index fund, which arguably has the highest growth potential of all my funds, out of these accounts to save a few bucks on my present day tax bill seems a little penny wise and pound foolish. However, this is more of a hunch on my part, I know we cannot predict future returns, and I am not sure if I am making this out to be a bigger issue than it is.

    Any help/thoughts would be greatly appreciated.

    Thanks

    Chuck

    • Justin September 4, 2017 at 5:10 pm - Reply

      @Chuck: Which asset class would you prefer to hold in your taxable accounts first? For an Ontario taxpayer, the annual taxes payable are expected to be very similar for all assets classes (even if US equities come out slightly ahead), so I don’t see any issues with choosing a different equity asset class for your taxable account if you prefer.

      Whether you should hold fixed income instead of equities in your taxable account first also has some merit, depending on your personal circumstances. For example, if you will be retiring shortly and are planning to withdraw from your taxable account first, you may prefer to hold a ladder of GICs in the taxable account first so that you do not have to realize any gains as you withdraw from the portfolio.

      I will also be writing some posts over the next couple of months on when it makes sense to hold fixed income in your taxable account first instead of equities.

  4. Ryan August 30, 2017 at 5:00 pm - Reply

    Awesome post.

    How does this change if we are holding the US listed version of US Equities within an RRSP to prevent the withholding tax? I’ve seen it recommended to hold US equities in an RRSP, would the lower dividend yield on US Equities change this as well?

    • Justin August 30, 2017 at 8:06 pm - Reply

      @Ryan: I’m not sure I understand your question as it relates to this blog post – would you mind elaborating a bit more? Thanks!

  5. Pascal Marcoux August 29, 2017 at 12:39 am - Reply

    Thanks Justin for this very good analysis. One questions though. You indicate that in jurisdictions with the highest eligible dividend tax rates, one should favour US equities first because you pay less taxes. However, the US equity dividend yield is roughly 1% less than the Canadian equity yield. Isn’t normal to pay less taxes if you have less dividend? On a per received dollar basis, wouldn’t you end-up paying 39 to 41% taxes for Canadian dividend VS 53-54% on US dividend in the last four provinces, still providing a small advantage for Canadian dividend? Or maybe there is something I don’t get.

    Thanks for clarifying,

    Pascal

    • Justin August 29, 2017 at 1:44 pm - Reply

      @Pascal Marcoux: The ultimate dollar amount of taxes you pay on your Canadian vs. US equities should be the focus (not just the difference in tax rates on the investment income). Even though Canadian eligible dividends are taxed more favourable, the higher dividend yield takes away some of this benefit (resulting in a similar tax liability to US equities in some jurisdictions).

  6. Kulvir August 28, 2017 at 10:55 pm - Reply

    Hi Justin,

    Thanks for the great post. Indeed, there is so much dogma that is adhered to. To add a a further layer of personalization, one has to consider the tax bracket that they are in, as the results will change with this as well. This of course adds a layer of complexity to the post. One way around this is to compare the top income bracket to the lowest, rather than each bracket. This is a more realistic scenario for many retirees.

    People, and sites, rarely consider after-tax performance of our returns and we rarely see posts such as this.

    Great post.

    • Justin August 28, 2017 at 10:59 pm - Reply

      @Kulvir: Thanks! Great point about the individual’s tax bracket having an impact on the results. I wanted to include a separate analysis (similar to what you had described), but the blog post was already becoming quite lengthy – so I just decided to add a few caveats along the way.

  7. Philippe V. August 28, 2017 at 5:02 pm - Reply

    Hello Justin, I want to add my thanks and appreciation as well. Amazing post!

    I took for granted that Canadian Equities should have priority in taxable accounts vs. other type of equities because of the canadian dividend tax credit.

    I know understand that eligible dividend tax rate and the equity dividend tax yield are what should help in the decision for asset location (with a few other considérations that you point out).

    • Justin August 28, 2017 at 5:05 pm - Reply

      @Philippe V: Thank you for your feedback – I’m glad to hear you enjoyed the post 🙂

  8. Bruno August 28, 2017 at 2:39 pm - Reply

    Fantastic post, Justin. Thank you for sharing this information!

    • Justin August 28, 2017 at 3:11 pm - Reply

      @Bruno: You’re very welcome! 🙂

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