Welcome back! In Part I of our series on Foreign Withholding Taxes on Foreign ETF Distributions, we took on foreign withholding taxes for equity ETFs. Today, we’ll cover the same for global equity, global bond, and asset allocation ETFs. Or again, if you’d prefer, you can tune into the full-length podcast version here.
Global Equity (ex Canada) ETFs
Before we press forward, remember, a global equity ETF is just a roll-up into a single global fund of the three foreign equity asset classes we covered in Part I: U.S., international, and emerging markets. Two popular examples are the iShares Core MSCI All Country World ex Canada Index ETF (XAW) and the Vanguard FTSE Global All Cap ex Canada Index ETF (VXC).
Until recently, Vanguard Canada used a tax-inefficient wrap structure in VXC. The fund gained its exposure to companies in Europe and the Asia-Pacific by holding two U.S.-listed international equity ETFs: the Vanguard FTSE Europe ETF (VGK) and the Vanguard FTSE Pacific ETF (VPL). This structure added an extra layer of foreign withholding tax on the international equity portion of the fund.
But that was then. As Scott Johnson from Vanguard Investments Canada covers in more detail in our companion podcast, Vanguard has since made some improvements to VXC. First, they sought to improve withholding tax efficiency by having VXC’s Europe and Asia-Pacific exposure come directly through a Canadian product, rather than by way of the U.S. They’ve also lowered the management fee from 25 basis points to 20 basis points.
After these recent changes, the foreign withholding tax implications for both VXC and XAW are now the same as for their individual underlying ETFs … with a noteworthy exception: If you hold VXC or XAW in an RRSP or RRIF – and the fund holds an underlying U.S.-listed U.S. equity ETF or a U.S.-listed emerging markets equity ETF – you do not avoid the 15% withholding tax on U.S. dividends.
Because of the additional tax drag in RRSPs and RRIFs, some investors prefer to hold a U.S.-listed global equity ETF instead, like the Vanguard Total World Stock ETF (VT). This ETF has similar exposure to XAW or VXC, but includes a 3% allocation to Canadian stocks. Keep in mind that VT is only more tax-efficient in an RRSP or RRIF account. VXC or XAW would likely be better choices for TFSA, RDSP, RESP, or taxable accounts.
In the charts below, the most optimal ETFs from a foreign withholding tax perspective for each account type will have all its cells shaded grey. For example, VXC and XAW are the most tax-efficient ETFs when held in TFSA, RDSP, RESP and taxable accounts, while VT is the most tax-efficient ETF for RRSPs and RRIFs.
Currency-Hedged Global Fixed Income ETFs
Onward into the realm of fixed income. Global fixed income ETFs are also subject to foreign withholding taxes on the coupon interest paid to foreign investors. The most common ETF structure for this asset class is a Canadian-listed ETF that holds a U.S.-listed ETF that holds the global bonds.
Although global bonds have not yet caught on with Canadian ETF investors, it’s still worth mentioning them, as many of the popular asset allocation ETFs include them.
For example, the Vanguard U.S. Aggregate Bond Index ETF (VBU) is a currency-hedged U.S. bond ETF that is included in all of Vanguard’s asset allocation ETFs. VBU holds the Vanguard Total Bond Market ETF (BND), which is a U.S.-listed ETF that holds U.S. government and corporate bonds. Although most U.S. coupon interest is exempt from withholding tax, there is a small portion that is unrecoverable in all account types except taxable accounts, where a foreign tax credit is available. At my last review, this tax drag was around 0.1% in registered and tax-free accounts, and fully recoverable in a taxable account.
The Vanguard Global ex-U.S. Aggregate Bond Index ETF (VBG) is another currency-hedged fixed income ETF, but it invests in global bonds outside of the U.S. VBG holds the Vanguard International Bond ETF (BNDX), which is a U.S.-listed ETF that holds global bonds, excluding U.S. bonds.
Similar to international and emerging markets equities, coupon interest from VBG is subject to two layers of foreign withholding taxes. The second layer from the U.S. to Canada is the most punitive.
In RRSPs and TFSAs, both layers of foreign withholding taxes are unrecoverable. So, at my last review, the tax drag was around 0.3%. In taxable accounts, the second layer of U.S. withholding taxes may be recoverable, so the expected drag is closer to around 2 basis points. Perhaps as a result of this additional tax drag, BMO and iShares have opted to exclude currency-hedged global (ex U.S.) bonds from their asset allocation ETFs, while Vanguard has included them.
Relative to Canadian bond ETFs, both currency-hedged global bond ETFs have higher MERs. With that, and the additional foreign withholding tax drag, I tend to exclude both from my clients’ portfolios … although that could change with future product improvements.
Asset Allocation ETFs
Finally, we have one-fund solutions, or asset allocation ETFs. The estimated tag drag for these ETFs would be similar to the weighted-average tax drags of Canadian-listed global (ex Canada ETFs) and currency-hedged global bond ETFs. That drag in RRSPs and TFSAs ranges between 0.04%–0.22%, depending on the product provider and whether the asset allocation ETF is conservative or aggressive. In taxable accounts, the annual unrecoverable withholding tax is expected to be a modest 1–2 basis points. Feel free to download my Foreign Withholding Tax Ratio (FWTR) Calculator for the most current figures.
The only way to reduce the foreign tax drag in your RRSP account is by breaking up with your asset allocation ETF. This would increase the complexity of your portfolio. But depending on your asset mix, it could reduce your annual costs by between 0.15%–0.30%.
If you go this route, remember you’ll need to purchase some ETFs with U.S. dollars, so you’ll need to be comfortable with the Norbert’s gambit strategy. You’ll also want your portfolio to be large enough to warrant the extra effort. If you’re interested in increasing your portfolio complexity from “light” to “ridiculous”, I’ve posted model ETF portfolios on my blog, to help you reduce the foreign withholding tax drag in your RRSP.
Coming Up on the Podcast: Asset Location Strategies
Congratulations, you’re nearing the end of our blog post/podcast series on managing foreign withholding taxes. In an upcoming Canadian Portfolio Manager podcast, we’ll take on another powerful investment technique worth mastering. If you liked thinking about foreign withholding taxes, you’re going to love diving into optimal asset location. See you then!