As mentioned in our initial foreign withholding tax lesson, the amount of foreign dividend withholding taxes you incur as an ETF investor depends on two important factors. The first is the structure of the ETF that holds the foreign stocks. And the second is the account type in which you hold the fund—such as an RRSP, TFSA, or non-registered account.

Depending on these two factors, your foreign dividends could be subject to one, or even two layers, or levels, of withholding tax.

Level I withholding taxes are those levied by the developed countries where the international stocks are domiciled, such us Japan, France, Switzerland, and so on.

Level II withholding taxes are incurred when the international stocks are held indirectly via a U.S.-listed ETF. Specifically, there’s an additional 15% U.S. withholding tax on the foreign dividends in certain account types before the U.S.-listed ETF pays the net dividends to Canada.

With this in mind, let’s look at the foreign withholding tax implications for the three international equity ETFs from our last video. To review, these include:

In terms of fund structure, IEFA is a U.S.-listed ETF that holds international stocks, while XEF and VIU are Canadian-listed ETFs that hold international stocks.

Both fund structures help you avoid the second layer of U.S. withholding tax if you hold them in RRSPs or RRIFs … but for different reasons.

For a Canadian-listed international equity ETFs like XEF or VIU, the first layer of foreign withholding tax still applies, based on foreign companies paying dividends to the Canadian fund. But because foreign dividends bypass the U.S. on their way to Canada, you get to avoid the second layer of U.S. withholding tax, regardless of the account type in which it’s held. It’s interesting to note, since January 1, 2015 (which is the first full calendar year XEF held their international stocks directly), the annualized tax drag has been similar to the fund’s MER.

Then there’s the U.S.-listed international equity ETFs like IEFA. They also still incur the first layer of withholding tax when the foreign companies pay dividends to the U.S. This structure also avoids the second layer of tax drag, as long as you hold it in an RRSP or RRIF. This time, the tax break is due to a treaty between Canada and the United States, which exempts these account types from the 15% U.S. withholding tax otherwise incurred.

So, bottom line, when holding an international equity fund in an RRSP, RRIF, or similar account, you can expect a similar overall tax drag whether you hold the U.S.-listed ETF that holds international stocks (like IEFA), or a Canadian-listed ETF that holds international stocks (like XEF or VIU).

Does that mean it doesn’t matter whether you prefer U.S. or Canadian-listed international equity funds for these account types? Before you reach that conclusion, please wait for our next blog/video, where we’ve got some additional points to cover.

What about holding international equity ETFs in TFSA, RESP, and RDSP accounts? For these, the preferred fund structure is a Canadian-based ETF like XEF or VIU, which holds the international stocks directly. This structure results in only one layer of foreign withholding taxes, while a U.S.-listed ETF like IEFA will be subject to two layers of foreign withholding tax on its international stock dividends. That’s because that U.S./Canadian tax treaty to exempt the 15% U.S. withholding tax does not exempt these account types. Plus, since January 1st, 2015, this second layer of taxes has been even more punitive than the first.

So, if you’re holding international equity ETFs in your TFSA, I’d suggest opting for the Canadian-listed ones like XEF or VIU.

I also prefer the same Canadian-listed ETF structure for non-registered accounts. Here too, only one layer of withholding taxes will apply – and even that layer is generally recoverable each year when you file your tax return.

Compare that to the other structure: a U.S.-listed international equity ETF like IEFA. Its foreign dividends are subject to the two layers of withholding taxes, and only the second layer of U.S. withholding tax is generally recoverable. So, for non-registered accounts, a Canadian-listed international equity ETF like XEF or VIU, is the preferred fund structure for reducing the foreign withholding tax drag.

Alright, that’s a lot to digest, so feel free to review the material again. Coming up in our next blog/video, we’ll determine whether it makes sense to hold IEFA in an RRSP to reduce your product costs. See you then!