Taxation of US-based ETFs covering other countries.

[DanielCarrera]

I'm interested in ETFs that cover EAFE and Emerging Markets. The cheapest ETFs are the ones from Vanguard, traded in the NYSE. Sure, iShares Canada has international ETFs too, but the MER is much higher.

I'm concerned about the effect of taxes on these ETFs though. In particular, withholding tax by the governments where the companies these ETFs invest reside. Germany and Brazil will surely want to tax my earnings...

The US will want to tax my earnings too, but at least we have a tax treaty with them. Inside an RRSP the US will tax nothing, and outside an RRSP the US will tax 15% on dividends but I'll get a tax credit. In any case, there is no cap gains tax from the US.

So, the US is not the issue. I'm concerned about the resident governments. How will the EAFE or Emerging government tax my capital gains and dividends? Is there a way to estimate the tax penalty for investing in them? I understand that if I used iShares Canada I'd get a tax credit. How big would that tax credit be? Big enough to compensate for the much higher MER of iShares Canada?

Any help would be appreciated. Thank you.

[Norbert Schlenker]

AFAIK the Canadian ishares are just covers for US ishares with a currency hedge thrown into the mix, i.e. XIN is full of EFA. So if there's Brazilian or German withholding tax for EFA, it also applies to XIN.

The issue of double withholding is a real one but you can't get around it by using XIN.

Note also that XIN appears to be less tax efficient for a taxable Canadian resident. The distribution on EFA last year was about 3% of NAV, as was the foreign income component of XIN's distribution. But then XIN adds on another 4% of NAV as a capital gain distribution.

[IdOp]

This thread has some related discussion.

[DanielCarrera]

AFAIK the Canadian ishares are just covers for US ishares with a currency hedge thrown into the mix, i.e. XIN is full of EFA... The issue of double withholding is a real one but you can't get around it by using XIN.

Oh. I didn't know that. Thanks. So it looks like there's no point in the iShares Canada ETFs that cover non-Canada markets.

If I may ask, what do you do in your portfolio? How do you minimize taxes on your non-Canada, non-US exposure? Or do you just invest less in other countries?

I'm beginning to think that I should under-weigh on EAFE. There is a tax penalty, I don't imagine it growing faster than the US long term, and it seems highly correlated with the US. So I've been asking myself "what's the point?".

For Emerging Markets I can still tell myself that they should grow faster than developed markets in the long term, and hopefully that compensates for the tax penalty.

[DanielCarrera]

This thread has some related discussion.

Thanks. I learned some things from that thread. Though I admit that I still don't confidently know what to do other than hope that my EAFE ETFs don't distribute dividends.

I'll have similar problems if I grab "EAFE Large Value" and "EAFE Small Cap" ETFs from iShares-US. They are likely to have more cap gains distributions which for a Canadian would be taxed as income Since they also have a higher MER (0.4% compared with 0.12% for VEA) I wonder whether the exercise is worth it or of it's just a waste of time. Maybe I should just stick to regular EAFE.

[IdOp]

I still don't confidently know what to do other than hope that my EAFE ETFs don't distribute dividends.

I know what you mean there. My own situation is I had all EAFE in a TD e-series fund. It had built up a large cap gain, so I planned to move it slowly to VEA because of the lower MER, and in fact started to do so with one chunk. Then I learned about the extra tax hit in that other thread. For now I've decided to just move the rest into CIBC Int'l index fund, where I get the MER rebate. This will avoid more foreign currency conversion on my part, and has some other conveniences, and I'll have some of that and of VEA to hedge my bets on which is better.

[DanielCarrera]

I still don't confidently know what to do other than hope that my EAFE ETFs don't distribute dividends.

I know what you mean there. My own situation is I had all EAFE in a TD e-series fund. It had built up a large cap gain, so I planned to move it slowly to VEA because of the lower MER, and in fact started to do so with one chunk. Then I learned about the extra tax hit in that other thread. For now I've decided to just move the rest into CIBC Int'l index fund, where I get the MER rebate. This will avoid more foreign currency conversion on my part, and has some other conveniences, and I'll have some of that and of VEA to hedge my bets on which is better.

Where can I learn more about this rebate? I'd be interested to know why they don't just lower the MER.

[IdOp]

Where can I learn more about this rebate? I'd be interested to know why they don't just lower the MER.

Very briefly, the rebate applies when your total holdings of eligible funds is over $150k. Some places to look are:

* ByLo.org's CIBC MER rebate page.

* CIBC funds' latest Annual Information Form (2007). Note to Bylo: time to update the link on your site!

* The FWF search feature.

[adrian2]

Where can I learn more about this rebate?

Check Bylo.

I'd be interested to know why they don't just lower the MER.

In a way, it's normal to offer rebates for large accounts, which take less basis points to administer - Vanguard has a similar program called Admiral for US investors.

[DanielCarrera]

Very briefly, the rebate applies when your total holdings of eligible funds is over $150k. Some places to look are:

* ByLo.org's CIBC MER rebate page.

Ok, thanks. So... if you have $150K with them the effective MER of their EAFE fund would go from 1.05% to 0.45%. In turn, if you use Vanguard's VEA you get:

- MER: 0.12%
- Tax of approximately 2% (dividends) x 15% (witholding) = 0.30%

So VEA's total is 0.42% against CIBC's 0.45% if you have $150K.

Hmm... I'm not convinced that CIBC's rebate is all that competitive after all. Sure, with VEA you have to pay commissions, but with CIBC you pay 1.05% until you accumulate $150K. That extra 0.60% on $140K is $840. That would pay for a lot of VEA commissions.

If you save $30K a year, so it takes you 5 years to reach the the $150K, that 0.60% would cost you at least $1,800. Using a standard broker with $20 trades, that buys you 90 trades, or 18 trades per year. If you only save $20K a year, it takes 7.5 years which costs you at least $3,360 which in turn means 24 trades per year at $20/trade.

[adrian2]

Ok, thanks. So... if you have $150K with them the effective MER of their EAFE fund would go from 1.05% to 0.45%.

To nitpick, the rebate is plus GST (as in the first update on Bylo's link). With the new GST of 5%, the rebate is worth 0.63% which makes the CIBC EAFE fund MER = 0.42%, identical to Vanguard's after tax cost.

Don't forget the cost and/or hassle of forex, ease of distribution reinvestment for a Canadian-based MF vs. the forex drag of distributions in an RRSP from non-Canadian based ETF's (until US$ RRSP's get more common) and CIBC looks a little more competitive. OTOH, tracking error can easily surpass a few bps.

[DanielCarrera]

To nitpick, the rebate is plus GST (as in the first update on Bylo's link). With the new GST of 5%, the rebate is worth 0.63% which makes the CIBC EAFE fund MER = 0.42%, identical to Vanguard's after tax cost.

Don't forget the cost and/or hassle of forex, ease of distribution reinvestment for a Canadian-based MF vs. the forex drag of distributions in an RRSP from non-Canadian based ETF's (until US$ RRSP's get more common) and CIBC looks a little more competitive. OTOH, tracking error can easily surpass a few bps.

Ok, they look more equal now. I'm still concerned about all the money CIBC would acquire while I save up $150K. That puts a dent on its competitiveness. But with the new data you posted I would rank the two options about equal.

I'm exploring the idea of holding EAFE stocks directly. Don't laugh. Sure, the EAFE index has 820 stocks, so even with dirt-cheap commissions it isn't feasible. But I'm looking for an index with fewer companies. For example, the S&P Global 100 index has only 100 companies and it covers the entire world (of course, large cap). Many of those companies are American (I'm trying to figure out how many). After the Americans are removed we might be left with a workable "International" index.

[blackball]

I believe that VEA will yield more than a 2% dividend. Without a full year's info, I used EFA and 70% VGK + 30% VPL as a proxy:

EFA: 2.59%
VGK+VPL: 2.94%

This was calculated using 2007 dividends and average weekly (friday) prices.

[DanielCarrera]

I believe that VEA will yield more than a 2% dividend. Without a full year's info, I used EFA and 70% VGK + 30% VPL as a proxy:

EFA: 2.59%
VGK+VPL: 2.94%

This was calculated using 2007 dividends and average weekly (friday) prices.

So we are talking closer to 2.7% dividend. If withholding tax is 15% (which could be totally wrong too) that would make the tax penalty 0.40%. Add the 0.12% MER and we get 0.52% So CIBC + rebate should "eventually" become cheaper in the long run. How long would depend on how long it takes to save $150K. For me that could be a long time, as EAFE is not planned to be a large part of my portfolio.

Either way, things don't look good.

[Icarus]

OTOH, tracking error can easily surpass a few bps.

I think that this point is worth highlighting. It's worth comparing the tracking error of Vaguard funds and CIBC index funds. Vanguard ETFs are relatively new, but you can use their index funds as a proxy. (They have a European and a Pacific index fund with a long history, but not an EAFE fund that I can see.)

So for tracking errors verus the index:

European Stock Index: +.04 (i.e. index fund outperformed index) over 10 years (ending 2/2008)

Pacific Stock Index: -.32 over 10 years (ending 2/2008)

CIBC Int'l Index: -1.64 (from inception to 2006)

The ETFs have MERs 10 bps less than the index, and CIBC gives a 63 bp rebate. Adding those to the above numbers gives +.14, -.22 and -1.01 respectively. So even with the loss of the foreign tax credit, Vanguard would have come out ahead (although the start and end dates are not the same). You also have to factor in forex and brokerage fees for the ETFs, of course.

As long as we're nitpicking, one other point is that some of the advantage of the foreign tax credit is lost for those who invest within corporations, since they do not receive the full FTC. This is relevant only to a minority of investors.

[blackball]

Is the foreign tax credit calculated at the lowest tax bracket or is it like a deductible (at the marginal rate)?

[DanielCarrera]

OTOH, tracking error can easily surpass a few bps.

I think that this point is worth highlighting. It's worth comparing the tracking error of Vaguard funds and CIBC index funds... Adding those to the above numbers gives +.14, -.22 and -1.01 respectively. So even with the loss of the foreign tax credit, Vanguard would have come out ahead

Wow, thanks! I hadn't thought of that. Thank you very much, that does make a big difference. I was just looking at TD e-Funds. eFunds EAFE has 0.5% MER. Do you know where I could find the tracking error for TD funds? I expect it'll be similar to CIBC, so Vanguard should come out ahead.

Thank you very much. The tracking error makes a world of a difference. I was actually seriously thinking of moving away from Vanguard.

As long as we're nitpicking, one other point is that some of the advantage of the foreign tax credit is lost for those who invest within corporations, since they do not receive the full FTC. This is relevant only to a minority of investors.

Could you explain this? Does this mean that if I get an ADR I wouldn't get a tax credit? Thanks.

[Icarus]

Do you know where I could find the tracking error for TD funds? I expect it'll be similar to CIBC, so Vanguard should come out ahead.

The numbers for the CIBC funds came from their annual report. I can't find the comparison with the benchmark in TD's annual report. If you go to Globefund, you can compare any fund with its benchmark but make sure they're using the same benchmark as you want.

I should sound one note of caution. I assumed that the benchmark return used in the CIBC report was the EAFE total return, although they don't explicitly say that. CIBC does explicitly state that the return of the index fund is given as a total return. Similarly, the benchmark on Globefund does not specify total EAFE return. Of course, the total return will be higher than the return that does not include distributions, so if the benchmark does not incude dividends then the performance of the CIBC index fund is even worse.

Could you explain this? Does this mean that if I get an ADR I wouldn't get a tax credit?

I'm referring to investments held in a CCPC, eg. holding company, operational company, professional corp, etc. I know nothing about ADRs. Sorry.

Is the foreign tax credit calculated at the lowest tax bracket or is it like a deductible (at the marginal rate)?

For US investments, I believe that due to the tax treaty you get full credit for any taxes paid if the investment is held personally. So if you received $100 and your MTR is 35%, you'd owe $35 to CRA. But if you paid $15 withholding tax, you'd only have to pay $20 to CRA. So I believe you get full credit at your top MTR. But I am really out of my depth here, and it may depend on tax treaties with other countries. Although you should always verify anything I say, you should really verify this! (And post the correction if I'm wrong.)

[ottovonclubington]

If I am a US citizen who is a permanent resident in Canada then how will my cap gains be taxed on US ETFs such as VTI. I thought I read somewhere on this forum that since cap gains are calculated differently for the US and Canada then in Canada's eyes US cap gains are merely taxed as regular income. Would I lose the 1/2 exclusion then?

[Bylo Selhi]

If I am a US citizen who is a permanent resident in Canada then how will my cap gains be taxed on US ETFs such as VTI.

Capital gains that arise from the sale of US-based ETFs (and other securities) are treated exactly the same as capital gains from the sale of Canadian ETFs (and other securities), i.e. the 50% exclusion applies.

I thought I read somewhere on this forum that since cap gains are calculated differently for the US and Canada then in Canada's eyes US cap gains are merely taxed as regular income.

Capital gains that arise from distributions from US-based ETFs (and other securities) are considered ordinary income for tax purposes. The same applies for all types of distributions from US-based ETFs, funds, etc. as well as to US stock dividends. In all cases they are considered ordinary income for tax purposes.

Notes:
1. Tax may be withheld by your broker on behalf of the IRS, however, you can claim this back on your Canadian tax return.
2. As a US citizen you are also required to file a US tax return, however, I'm not familiar with that process. Presumably you'd report capital gains based on US tax rules in order to determine your liability to Uncle Sam.