(This post applies to Canadians only. Taxes vary by jurisdiction so it may be different in your area.)
John Heinzl at The Globe & Mail, in one of his columns, goes through the tax treatment of US dividends for Canadian investors. To put it bluntly, US dividends will be taxed at the marginal tax rate (assuming you are not using a tax-sheltered account.) What I never knew before reading the article was how TFSA accounts, which were introduced this year, are treated.
Note that the rules will be different for other countries. Taxes, whether on dividends, or capital gains, or some other source, are dependent on tax treaties between countries. So, for example, dividends from Japanese stocks for a company listed on the Tokyo Stock Exchange will be different. I'm not sure how taxes are handled for a Canadian investor owning an ADR of a foreign company listed on the NYSE.
Also, this post, and the original Globe & Mail article I will be citing, covers normal dividends. Income paid out by income trusts (Canada/Australia), Master Limited Partnerships (USA), "flow-through" units, and so forth, often involve greater complexity and may or may not be treated the same as regular dividends. Return of capital, sometimes mistakenly thought of as dividends by some, also generally involve more complex tax treatment and I'm not sure if what I say in this post applies to them.
US Dividends Within RRSP/RRIF
First, how US dividends are treated within a tax-sheltered account such as RRSP or RRIF:
Inside a registered retirement savings plan (RRSP) or a registered retirement income fund (RRIF), there's no withholding tax on U.S. dividends. So the entire amount will land in your account – adjusted for currency. That's why many investors prefer to hold U.S. stocks inside an RRSP.
Pretty basic and is kind of what one would expect: no taxes paid on dividends. You pay neither the witholding taxes (extracted by USA in this case) nor any taxes on the dividend (that Canada would extract.)
The tax treaty between countries would have to specify how dividends are handled. Other countries may not provide favourable treatment of dividends as the US case. I'm not an expert and haven't seen it happen, but if there were no treaty between countries, I suspect that you will get charged the witholding tax. And you probably won't get credit for the witholding tax (in contrast, if this were a taxable account, you can almost always claim a credit for witholding taxes charged by foreign governments.)
US Dividends With No Tax Shelter
The standard case where you receive US dividends in your normal (non-tax-sheltered) account is as follows:
For starters, you'll pay a 15-per-cent U.S. withholding tax off the top. Also, because U.S. dividends don't qualify for the Canadian dividend tax credit, when you file your return you'll pay tax at your marginal rate on the full amount of the dividend. The good news is, you'll be able to claim all or part of the 15-per-cent withholding tax as a foreign tax credit.
Yes, it's confusing, but the net effect for most people is that, in a non-registered account, U.S. dividends are taxed at the same rate as interest income.
I didn't know that you get charged a witholding tax on your dividend but, then again, I don't generally invest in dividend-oriented companies. You get a credit but I hate doing the paperwork for that :(
Overall, in this scenario (no tax-shelter), US dividends get taxed at your marginal tax rate. This makes dividends (at least US ones, and likely all other foreign dividends) unattractive! You pay the same rate as you do on your (wage/salary) income or on interest from bonds/cash. This means that you are just as better off owning US bonds.
What is described here only applies to foreign dividends. If you were getting qualified Canadian dividends, you are better off receiving dividends than interest from a bond. Canadian dividends are taxed at a lower rate; while interest is taxed at your (higher) marginal rate.
I'm not a dividend-oriented investor but if you were, and are living in Canada, you should attempt to find Canadian companies for your non-tax-sheltered account. You do not get any benefit (strictly speaking from a tax point of view) with a US dividend (compared to interest on a bond.)
This scenario describes another reason to not like dividends. If you owned a foreign company, you should get it to avoid paying dividends to you. Not only do you end up paying a higher tax rate (same as marginal rate), the company also gets double-taxed. You would be better off if the company bought back shares (hopefully not when wildly overvalued) or re-invested in the company (hopefully in successful projects.) The double-taxation plus your own higher taxes makes a case for avoiding dividends.
US Dividends Within TFSA
Anyway, the thing I learned from this article was how US dividends are handled in the newly-introduced TFSA:
Tax Free Savings Accounts add yet another layer of complexity. Because TFSAs – unlike RRSPs and RRIFs – are not strictly a retirement vehicle and are therefore not covered by the Canada-U.S. tax treaty, U.S. dividends are subject to the 15-per-cent U.S. withholding tax, says Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth Management.
What's more, the withholding tax can't be claimed as a credit. So on a $100 dividend the investor will end up with $85, which for most people is still better than paying tax on the dividend at their marginal rate.
The TFSA scenario is a weird one, at least to me. You pay the witholding tax but no other taxes. It's sort of half-way between the other two scenarios.
Hope some Canadian readers found this post useful. If you are using a normal investment account (no tax shelter), you should probably forget about US dividend-oriented companies and try to find some Canadian ones. If you were using a tax-sheltered account, then US dividends are ok for dividend-oriented investors.
If you are not a dividend-oriented investor then it gets complicated. Even if you pay the lowest dividend taxes in a tax-sheltered account, you may be better of shielding capital gains instead. So you are probably better off owning US bonds (assuming risk-return characteristics are comparable) in your normal account and using your tax-sheltered account for capital-gains-oriented investments. However, as anyone that has lost money will know full well, you can't write off losses in your tax-sheltered account. So it's not as simple as it seems.
I haven't found an optimal solution for my situation yet. Right now, I attempt to use non-tax-sheltered account for my low confidence investments (so that I can write them off if they blow up.) I haven't bought anything yet but my goal is to buy high yield bonds in my tax shelter.
Oh, one final note...tax laws change over time so if you are reading this in 2020, check the official documents. Canada could be at war with USA and you may not get any credit for US witholding taxes ;)
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About This Blog
- Sivaram Velauthapillai
(This post applies to Canadians only. Taxes vary by jurisdiction so it may be different in your area.)