Foreign withholding tax: Is the credit always worth it?

Given Canada’s relatively small share of global capital markets, many investors seek opportunities to invest outside our borders to achieve their portfolio objectives.

But foreign dividend-paying stocks are usually accompanied by taxes paid to foreign governments via non-resident withholding tax. The Income Tax Act has provisions for refunding most of this foreign tax through the foreign tax credit when foreign stocks are held in taxable investment accounts. When such stocks are held in registered accounts (an RRSP or TFSA, for example), this credit is not available. Should clients still hold foreign dividend-paying stocks in these accounts?

Foreign dividends and taxes

For Canadian tax purposes, foreign dividends are taxed like interest income—that is, they are fully taxable. Unlike eligible Canadian dividends, there is neither a gross-up nor a dividend tax credit. Also, foreign dividends are usually subjected to foreign tax, which is deducted before each dividend is paid to the investor. This foreign withholding is generally between 15% and 25%.

To address this foreign tax, there is a federal, and sometimes provincial, foreign tax credit available. This credit is designed to reduce or eliminate double taxation by reducing Canadian tax owing on the same foreign source of income, such that the total tax paid (foreign and Canadian combined) is the same as the individual’s Canadian marginal tax rate. The federal credit is 15% of net foreign non-business income, such as dividends.

As noted above, the foreign tax credit is not available for foreign income received in registered accounts, even though foreign tax will still be withheld at source for securities held in these accounts.

One notable exception relates to U.S. dividends earned in RRSPs, RRIFs and locked-in accounts. Thanks to the Canada-U.S. tax treaty, U.S. dividends in these accounts are subject to a 0% foreign withholding tax (upon completion of a U.S. W-8BEN form). This exception does not apply to U.S. dividends received in a TFSA or other Canadian registered accounts. While this typically relates to dividends paid by direct holdings of U.S. stocks, certain mutual fund trusts may qualify for the exemption as well.

Registered accounts or foreign tax credits?

Consider Lucille, a Canadian resident in a 40% marginal tax bracket. She is looking to add $33,333 pre-tax ($20,000 after-tax) worth of a foreign (non-U.S.) dividend-paying stock to her portfolio that is subject to a 15% non-resident withholding tax at source. The stock pays an impressive 5% annual dividend.

She can choose to hold the pre-tax amount of this stock in an RRSP, or the after-tax amount in a TFSA or non-registered account. After the dividend is paid, she will withdraw it and deposit the proceeds to her bank account. Assuming this investment meets her stated investment and portfolio objectives, where should she purchase this stock?

Compared to a non-registered account, the TFSA provides the higher after-tax dividend despite being ineligible for the foreign tax credit because no Canadian tax applies. This makes Lucille’s tax rate 15% instead of 40% on this dividend.

The RRSP is funded with pre-tax dollars, which makes its comparison a little trickier. However, if we adjust for this, we see that the after-tax dividend is the same as the TFSA’s.

*All numbers are in Canadian dollars

But don’t be deceived: this does not mean the tax rate that applies is the same. In fact, when the foreign dividend is earned in the RRSP, it is subject to the foreign withholding tax at source and Canadian tax upon withdrawal at Lucille’s full marginal tax rate, with no foreign tax credit.

While the TFSA has the lowest tax cost in this example, Lucille ends up with the same after-tax dividend ($850) in the RRSP. Numbers should always be crunched based on the specific fact pattern to determine what’s best. For example, if Lucille purchased a U.S. stock, the RRSP would have the highest after-tax dividend ($1,000) thanks to the 0% foreign withholding tax and investment of pre-tax dollars. The TFSA and non-registered results would remain unchanged.

Summary

When adding suitable investments to a portfolio, you can evaluate their associated tax cost to help clients determine where they want to hold that investment. With foreign dividend-paying securities, there may be a tax cost regardless of the account used to make the purchase. The question is whether or not the foreign tax credit is worth it.

Curtis Davis , FMA, CIM, RRC, CFP, is senior consultant, Tax, Retirement & Estate Planning Services, Retail Markets at Manulife.

Curtis Davis

Tax & Estate

Curtis Davis, FCSI, CFP, TEP, is director for tax, retirement and estate planning services, retail markets at Manulife Investment Management.