Small Print TFSA Rules Affecting U.S. Stocks

Give this article a read before you buy and hold U.S. stocks inside a TFSA.

Key Points
  • U.S. dividend-paying investments held in a TFSA are generally subject to a 15% U.S. withholding tax, reducing the income you receive.
  • Investors can usually avoid the withholding tax by holding qualifying U.S. dividend investments in an RRSP or recover some of it through the foreign tax credit in a non-registered account.
  • Canadian-U.S. dual citizens should seek cross-border tax advice before using a TFSA because the account is not recognized as tax free by the United States.

If you’ve ever opened a Canadian brokerage account, there’s a good chance you were asked to complete a W-8BEN form. Most investors sign it without giving it much thought.

The form tells the U.S. Internal Revenue Service (IRS) that you’re a Canadian resident eligible for the tax treaty between Canada and the United States. Among other things, it generally reduces the default U.S. withholding tax on dividends from 30% to 15%.

So, why does that matter for your Tax-Free Savings Account (TFSA)? Because depending on what you invest in, some of the tax rules you assumed applied to your TFSA may not actually hold true. Here are two of the biggest ones that tend to surprise investors.

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The 15% foreign withholding tax

The biggest surprise is the U.S. foreign withholding tax on dividends. Suppose you own an S&P 500 index fund yielding 1% annually. After the 15% withholding tax, your effective dividend yield falls to 0.85%.

That may not sound like much, but it creates a small drag on long-term compounding because less dividend income is available to reinvest. The rule applies to U.S. stocks held directly as well as U.S.-listed exchange-traded funds (ETFs) that own U.S. stocks.

Canadian-listed ETFs that invest in U.S. stocks are also affected. In those cases, the withholding tax is generally deducted inside the fund before distributions are paid, meaning investors often never see the deduction directly.

There are only a couple of ways around it. If you hold U.S. dividend-paying stocks or qualifying U.S.-listed ETFs inside a Registered Retirement Savings Plan (RRSP), the Canada-U.S. tax treaty generally exempts those dividends from withholding tax.

Alternatively, investors holding U.S. investments in a non-registered account may generally claim a foreign tax credit to help offset some or all of the withholding tax paid.

Dual citizens face different rules

If you are both a Canadian and U.S. citizen, or otherwise remain subject to U.S. taxation, the TFSA can create additional tax reporting complications because the United States does not recognize the TFSA as a tax-free account.

That means income and gains inside the account may still be subject to U.S. tax rules and reporting requirements, potentially eliminating many of the tax advantages Canadian residents normally enjoy.

As a side note, similar issues also apply to the Registered Disability Savings Plan (RDSP). While the RDSP receives favourable treatment under Canadian tax law, it generally is not recognized by the United States as a tax-advantaged account.

By contrast, the Registered Retirement Savings Plan (RRSP) is recognized under the Canada-U.S. tax treaty, making it much more straightforward from a cross-border tax perspective.

Cross-border tax rules are highly specialized and depend on your individual circumstances. For that reason, dual citizens should generally consult a qualified cross-border accountant or tax professional before opening or contributing to a TFSA.

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