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Dear Fellow Fools,
Happy New Year to all! With the holiday season now behind us, we’re fast approaching two other seasons that have financial implications for almost all of us: tax season and RRSP season.
It wasn’t so long ago that we weren’t allowed to have more than 30% of our registered retirement savings (i.e., RRSP) allocated to non-Canadian holdings. How narrow our choices used to be!
Fortunately, the federal government came to its senses and, in early 2005, a monumental event occurred for Canadian investors: the stringent rules on foreign stock holdings were lifted.
Abolishing the 30% threshold on foreign holdings did more than just open up our retirement savings to a world of investing that we’d previously been (partially) sheltered from. It really changed the way many of us thought about all of our investment accounts, registered or not.
We were finally free to do as we pleased with our hard-earned savings!
The price of freedom
Though the ability to invest where we want is a huge boon, as more choice is generally better than less, there are tax implications associated with investing in foreign shares.
While we in no way think these tax implications should prevent us from investing abroad, which is why in every issue of Stock Advisor Canada we present one Canadian and one U.S. recommendation per month, it’s important to have a handle on what the tax issues are. And while Fools are happy to talk stocks until we’re blue in the face … we know our limitations.
To bring you top-notch insights on the issue of foreign investment taxation, we leveraged an expert in the field, Mr. Ben Alarie. Ben holds an LL.M from Yale University and an M.A. and J.D. from the University of Toronto, where he is now a professor and Associate Dean, First Year Program at the Faculty of Law. Taxation law happens to be one of Ben’s specialties and one of the principle areas he teaches. Few are better qualified when it comes to this topic.
Ben has outlined a timeline of sorts below that encompasses all of the steps a Canadian investor must take when they transact in foreign shares. At each step along the line, the relevant issues with taxation are outlined. It’s a fast and easy way to get comfortable with one of the most important considerations to keep in mind when you invest outside of Canada.
Following Ben’s timeline, we provide some commentary on a few of his most important points.
1. When you buy foreign shares
- Currency has to be converted from Canadian dollars as of that day’s exchange rate. This will establish your Canadian dollar adjusted-cost-base (ACB) of the shares. (Note: This is not a manual process; it is typically taken care of by your broker.)
- You can add the trading and other related costs of buying the stock to your ACB.
- If you want to sell your foreign shares shortly after buying them (a practice Fools would never encourage!), you cannot “automatically” get capital gains/capital losses treatment on your foreign trades. The Canadian securities election applies only to Canadian securities and not to foreign shares. If you’re day-trading/speculating rather than investing, you may have to consider any appreciation in the shares to be business income and not capital gains.
- If you are buying the stock within an RRSP or TFSA (i.e., a tax-sheltered account), then this doesn’t matter as much.
2. When you buy some more of the same foreign shares
- You will need to attend to all of the above issues.
- You will need to average the cost of the shares if they are identical to the ones you already own (i.e., if it’s the same ticker).
3. When you hold foreign shares
- The income you receive will usually be dividends.
- Foreign source dividends will usually be subject to “gross withholding taxes” in the source jurisdiction.
- If there is a tax treaty (and there almost always will be) between Canada and the other country, the gross withholding tax rate is usually reduced according to the terms of the treaty. (See, for example, the Canada-U.S. treaty and the long list of in-force tax treaties for Canada, here: https://www.fin.gc.ca/treaties-conventions/in_force–eng.asp.)
- You can generally claim a foreign tax credit (FTC) for the amount of the gross withholding tax that you pay to the other country’s government. This means that you get to reduce the Canadian tax you have to pay by the amount of foreign tax already collected.
- Dividends from U.S. stocks flow into an RRSP without being subject to the withholding tax (not all foreign jurisdictions qualify). This is not the case, however, with a TFSA or RESP. U.S. stocks held within these accounts are still subject to withholding tax on dividends paid (again, other jurisdictions may be different).
- If you’re investing in real estate investment trusts (REITs) or other instruments (like a master limited partnership, or MLP) that are not true “corporate shares” but rather “trust units,” there may be a different withholding tax rate that applies under the tax treaty. You’ll need to read the individual treaties (it’s fun!) to know what this tax treatment is.
4. When you sell some (or all) of your foreign shares
- Remember that your gains could be capital gains (in most cases) or business profits (if you’re a day trader/speculator).
- You can generally deduct the costs (i.e., commission) associated with selling the shares from the proceeds of disposition.
- You need to figure out what the proceeds of disposition are in Canadian dollars on the date of sale and deduct the averaged Canadian dollar ACB (calculated based on the average cost of the shares given the exchange rates and amounts paid for shares on the various acquisition dates). (Note: This is not a manual process; it’s typically taken care of by your broker.)
- To the extent that the foreign jurisdiction taxes you on the capital gain/business income from selling the shares, you may have to pay tax in that jurisdiction.
- The tax that you pay in the other jurisdiction will generally benefit from a Canadian foreign tax credit.
5. An additional consideration: What if I have more than $100,000 in foreign assets?
- You have to declare this on your annual tax return. This is not a big deal.
- Canada taxes its residents on worldwide income, so the question is meant to alert the CRA to non-trivial foreign holdings.
- If you are holding the foreign assets through an RRSP or TFSA (i.e., a registered account), again, this is not as much of an issue.
Some good additional sources:
Because taxes are a rather slippery subject with all kinds of permutations caused by personal economic circumstances, this is a difficult issue to throw a non-personalized blanket over. For specific inquiries, we highly recommend you consult a tax professional, who can zero in on your individual situation.
By no means are we trying to suggest this is a comprehensive overview. However, we’d like to emphasize the following points — as they are likely to pertain to most of us in our day-to-day interactions with foreign, and especially, U.S. stocks.
The three big takeaways from Ben’s timeline:
1. Foreign stocks that are held in a registered account (RRSP, TFSA) are largely void of capital gains related tax considerations – just like Canadian stocks.
2. Assuming your trading activity does not constitute business income (most of us), capital gains/losses from foreign holdings in non-registered accounts are taxed in largely the same manner as Canadian stocks. The big difference is that the foreign exchange movements must be considered. These movements will either accentuate or reduce the gain or loss.
Here’s a curve ball, though. According to the CRA’s Capital Gains Guide for 2012, you only have to report the amount of your net FX gain or loss for the year that is more than $200. If the net amount is $200 or less, there is no capital gain or loss on foreign exchange and you do not have to report it.
3. The treatment of dividends is the final key takeaway – and to keep this as straightforward as possible, let’s stick with the treatment of dividends from U.S. stocks.
For all non-registered accounts, as well as TFSAs and RESPs, dividends from U.S. stocks are subject to a 15% withholding tax that is clipped at the source. You can generally claim a foreign tax credit for the amount withheld, which allows you to reduce the Canadian tax you have to pay by the amount of foreign tax already collected.
U.S. dividends received into an RRSP account are not subject to this 15% withholding tax.
Also, U.S. dividends received into a non-registered account are treated as income. Canadian-based dividends receive a special tax treatment that U.S. dividends are not granted.
From a tax perspective, holding U.S. dividend stocks in an RRSP is the most efficient place for them.
The Foolish Bottom Line
We Canadian Fools are firm believers that all Canadian investors need to expand their portfolios beyond the borders of our fair land to set themselves up for the best possible risk-adjusted returns. And we’ve put our beliefs into practice with Stock Advisor Canada.
While tax is a consideration, we hardly think it warrants an aversion to the opportunities that abound outside of the Canadian market. With at least some degree of comfort with these considerations, we hope that more Canadian will broaden their investment horizon.
Special thanks to the University of Toronto’s Ben Alarie for helping us navigate some of the primary tax-related considerations that surround investing in foreign, but especially, U.S. stocks.
Ask a Fool
As always, we love hearing from our community of Fools and want to remind you that you can utilize our “Ask a Fool” service to put forward whatever investment related issues might be on your mind. Simply e-mail us at [email protected].
Chief Investment Advisor
Motley Fool Canada