By now, you’re probably getting the hang of how to handle foreign withholding taxes, based on our past blog/video on international equity ETFs. But complex lessons bear repeating. So, this time, let’s take what you’ve learned on foreign withholding taxes, and apply it to emerging markets equity ETFs.
Recall that the amount of withholding tax payable on foreign dividends depends on two important factors:
The first is the structure of the ETF that holds the stocks. The second is the account type in which you’re holding the ETF. By account type, we’re talking about whether the ETF is an RRSP, TFSA, non-registered account, and so on.
Depending on these two factors – structure and account type – the foreign dividends on your emerging markets stock ETF could be subject to one, or even two layers of withholding tax.
Level I withholding taxes are those levied by the developing countries where the companies are domiciled, such us China, Brazil, and so on.
Level II withholding taxes are incurred when the emerging markets stocks are held indirectly via a U.S.-listed ETF. In some account types, there’s an additional 15% U.S. withholding tax on foreign dividends before the U.S.-listed ETF pays the net dividends to Canada.
With this in mind, let’s look at foreign withholding taxes for the emerging markets equity ETFs we introduced in our last lesson:
- The Vanguard FTSE Emerging Markets ETF (VWO)
- The Vanguard FTSE Emerging Markets All Cap Index ETF (VEE)
- The iShares Core MSCI Emerging Markets ETF (IEMG), and
- The iShares Core MSCI Emerging Markets IMI Index ETF (XEC)
In terms of fund structure, VWO and IEMG are considered U.S.-listed ETFs that hold emerging markets stocks. VEE and XEC are Canadian-listed ETFs that hold U.S.-listed ETFs that hold emerging markets stocks.
When held in an RRSP or RRIF, funds such as XEC or VEE are subject to two layers of foreign withholding taxes. That’s because they are Canadian-listed ETFs that gain their exposure to emerging market stocks by holding a U.S.-listed ETF. The first layer of withholding tax occurs when the foreign companies pay dividends to the U.S. The second layer is levied when the foreign dividends are paid from the U.S. to Canada. Since January 1st, 2014, the combined level 1 and level 2 foreign withholding tax drag has been substantial.
In contrast, U.S.-listed emerging markets equity ETFs, like IEMG or VWO, still incur the first level of withholding tax when the foreign companies pay dividends to the U.S. However, this structure is exempt from the second 15% layer of U.S. withholding tax when held in an RRSP or RRIF. As we’ve mentioned in the past, that’s due to a tax treaty between Canada and the U.S. And, at least from the perspective of reducing foreign withholding taxes, this makes IEMG and VWO superior choices for your RRSP or RRIF.
What if you’re holding emerging markets equity ETFs in TFSA, RESP, and RDSP accounts? No tax treaty exists between Canada and the U.S. to exempt the 15% U.S. withholding tax in these account types. So, regardless of the structure, your investment will be subject to two similar layers of foreign withholding taxes. Again, strictly from a foreign withholding tax perspective, it doesn’t matter which fund you choose.
Last, let’s look at holding emerging markets ETFs in your non-registered accounts.
When you hold a Canadian-listed ETF like XEC or VEE—which holds a U.S.-listed ETF that holds emerging markets stocks—both layers of withholding taxes will apply – although the second layer of U.S. withholding tax is generally recoverable each year when you file your tax return.
For a U.S.-listed ETF, like IEMG or VWO—which directly holds the emerging markets stocks—the foreign dividends are also subject to two layers of withholding taxes, and, again, the second layer of U.S. withholding tax is generally recoverable.
So, for foreign withholding taxes in non-registered accounts, neither fund structure has an advantage over the other.
Once again, this foreign withholding tax material can be tricky, so feel free to review the content again if the concepts have got you stumped. In our next blog/video, we’ll review the impact of currency conversion fees when buying or selling U.S.-listed emerging markets equity ETFs. See you then!
May I request a blog post on how to invest in a first home savings account? This one is tricky because there’s a limited time horizon, max of 15 years. It would suck if the market happened to be down on the 15th year.
@Sd – Great blog idea! In the meantime, you could consider taking a similar approach as in my RESP glidepath strategy (but perhaps starting at around 75% equity and getting more conservative from there…assuming you’ll be invested for the full 15 years):
Thanks! The FHSA has an even shorter/uncertain time horizon than the RESP because most people probably wouldn’t be waiting 15 years from the time they first contribute.
BlackRock just announced today March 13, 2023 that XEC will undertake a direct investment strategy in the MSCI Emerging Markets Investable Market Index instead of holding IEMG.
1. Am I right that (the new) XEC will have small-cap emerging stocks (since it follows the IMI – Investable Market Index), unlike ZEM which does not have small-cap emerging stocks?
2. As with the case with XEF/IEFA, I’d presume that XEC, like XEF, will eventually be cheaper than holding its corresponding US-listed version but with FWTR.
3. May I know when is a good time to switch back VWO/IEMG, assuming a tax-loss selling opportunity turns up, i.e. how long will this change to XEC take to stabilize? Right now, the press release mentions net capital losses are expected from this, so presumably from 2024 onwards might be best.
@Gary – You receive the CPM award today for most useful information! :)
This is excellent news (other than I need to redo my video).
1. Yes, XEC is expected to hold small cap stocks directly (probably not every one from the index, but a sampling of them).
2. Correct, except in RRSPs (assuming you use Norbert’s gambit to convert CAD to USD).
3. Not sure how long it will take – but in order to track its index closely, XEC would need to enact the changes quickly.
So glad I read the comments on this (as I currently hold XEC in a TFSA and was considering juggling my asset allocation to move it into IEMG in an RRSP to optimize). Great news for XEC! I looked on the iShares.ca site just now and already in the detailed holdings, they report holding the equities directly (vs. other funds where they show the US-listed ETF held by the fund). So… I am concluding they have made the switch already?
Now if the MERs of the XEC and XEF would just be lowered to US-levels, I’d be perfectly happy. :)
@Dwilly – Haha, I wouldn’t hold your breath for lower MERs on XEC or XEF ;)
thanks for the nice post on emerging markets withholding taxes.
any thoughts on ZEM? from what I understand it holds most of the equities directly, so it should not incur the level 2 withholding tax. since the withholding taxes are better for ZEM, are there other downsides that you do not consider it in the evaluations?
@Kasra – ZEM is another excellent option for emerging markets equity exposure. The main downside is that it excludes small-cap stocks (so it is unfortunately not directly comparable to either XEC or VEE).
Hello Justin – I hold XEC in my TFSA and will be unable to avoid both layers of withholding tax on this ETF. In a previous video you had mentioned that ZEM will not incur the second layer of withholding taxes as it holds the individual securities in the ETF, but that the resulting tracking error would cost more than the saved taxes. Is this still the case with ZEM?
@Grant Partington – The last time I checked, ZEM was actually tracking its index more closely, so it seems to have fixed its tracking error issues.
Thank you Justin. You have brought so much transparency to this issue over the years for the benefit of Canadian investors!
I understand there is a third category of emerging market equity ETF available in Canada: a Canadian listed ETF holding emerging market stocks directly. I believe BMO’s ZEM falls into this category. From a withholding tax point of view is it true this structure has the least foreign withholding tax “drag” regardless of the account type in which it is held? Thanks again, keep up the good work, and kind regards!
@Alan – I haven’t crunched the numbers for a while now, but the last time I had, they indicated ZEM was more tax-efficient than XEC or VEE, and it was also tracking its index closely enough to not offset these tax benefits.
Thanks for all the posts, Justin.
I have been using VT (https://www.canadianportfoliomanagerblog.com/under-the-hood-global-equity-etfs-part-iii-vt-and-vxc/) and while following your blog posts, am also understanding that the WHT savings are for the US equities held by VT.
With this post, I was now wondering if there’s benefits of splitting VT into VTI plus VXUS, or would it effectively be similar to holding VT?
If I understood this post correctly, it appears that VTI plus Canadian-listed ETFs would result in more tax drag (level 2 WHT) so I removed that option from the equation.
Thanks in advance!
@Jonathan – VT would be similar to holding VTI and VXUS, from a foreign withholding tax perspective.
Very interesting. How do you get -0,31%, -0,38%. Thank you so much. Denis
@Denis Lemelin – With an excel spreadsheet and A LOT of patience ;)