Tax & Estate planning

Foreign withholding tax on ETF and mutual fund investments

February 29, 2024
Invesco Tax & Estate team
Invesco Tax & Estate team
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Key takeaways
Diversification commonly means holding marketable securities in both Canadian and foreign markets
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Those securities may be held directly (e.g., stocks and bonds) or through pooled structures (or funds) such as exchange-traded funds (ETFs) and mutual funds (MFs).
Managing the tax impact of foreign investments
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For an investor to understand and report income originating from foreign sources, the potential combinations and permutations can be confusing.
The different tax scenarios for foreign investments
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This article analyzes the flow of foreign income and the incidence of foreign withholding tax for Canadians through four scenarios.

Depending on how an investor holds foreign securities, foreign withholding taxes may apply. Here is a quick reference that walks through four different scenarios. 

Foreign withholding taxes on ETF and mutual fund investments

A diversified portfolio opens opportunities for an investor while concurrently assisting in managing risk. In addition to holding different asset classes, diversification commonly means holding marketable securities in both Canadian and foreign markets. Those securities may be held directly (e.g., stocks and bonds) or through pooled structures (or funds) such as exchange-traded funds (ETFs) and mutual funds (MFs). While most Canadian investors will hold Canadian ETFs and MFs, an investor could also hold a fund resident elsewhere, with the United States being the next most likely jurisdiction. In turn, a foreign ETF or MF may invest in its own domestic securities or beyond its borders. Finally, a fund may hold another fund, and that latter fund may be Canadian or foreign-resident.

For an investor to understand and report income originating from foreign sources, these potential combinations and permutations can be confusing. As well, the incidence and mechanics of foreign and domestic tax must be managed.

This article is a quick reference guide that shows how foreign withholding taxes may apply under each structure and how withholding tax is reconciled for Canadian tax reporting purposes.

Let’s analyze the flow of foreign income and the incidence of foreign withholding tax through four scenarios.

In Scenario A, a Canadian-resident individual invests directly in foreign stocks and bonds in a taxable (or non-registered) account. Investment income generated and paid to the investor from the foreign securities is first subject to foreign withholding tax. This is the first layer of withholding tax. The rate of foreign withholding tax varies and may be reduced by way of a tax treaty between Canada and the foreign jurisdiction. For direct investments in U.S. securities, the treaty may exempt the income from U.S. withholding tax. 

Scenario A – Taxable account – Investor holds foreign securities directly

     
  Flow of foreign income Incidence of foreign withholding tax 
     
1

Foreign securities
  • Foreign stocks and/or bonds are held directly; dividends from foreign stocks and interest from foreign bonds are issued directly to the investor

  • Note that Canadian-domiciled/resident securities (e.g., Canadian ETFs or MFs holding foreign securities) are not considered foreign securities
2 Foreign withholding tax on income
  • Investment income earned is subject to a foreign withholding tax at source

  • Foreign withholding tax may be reduced by way of tax treaty between Canada and the foreign securities' jurisdiction

  • Gross amount of foreign income is taxed on the investor's Canadian tax return (if a Canadian resident)

  • Net amount (after deducting foreign withholding tax) is paid into the taxable account
3 Foreign income to Canadian resident
  • If the investor is a non-resident of Canada, skip to #4 below

  • Amounts received are reported on a Canadian tax slip with the total amount of foreign taxes paid and gross foreign income earned

  • A T3 tax slip is issued for Canadian ETFs and MFs that are trusts; a T5 tax slip is issued for ETFs and MFs that are corporations

  • The foreign tax credit may be used to reduce some of the foreign taxes paid on the Canadian income tax return

  • Foreign income is designated as "foreign non-business income" and foreign taxes paid are designated as "foreign non-business income taxes paid”
4 Foreign income to non-Canadian resident
  • A further layer of Canadian non-resident withholding tax applies to a non-Canadian-resident accountholder

  • The rate of Canadian non-resident withholding tax is 25% unless reduced by a tax treaty between Canada and the investor’s foreign-resident jurisdiction

  • Reduced treaty rates are generally only available if a completed NR301 form (or equivalent) is on file with the Canadian financial institution

  • An NR4 tax slip (instead of a T3/T5) is issued with a summary of the gross payments and total Canadian non-resident withholding taxes taken

In Scenario B, the same Canadian-resident individual holds the foreign securities indirectly through a Canadian ETF or mutual fund. In this scenario, there is only one layer of withholding tax, despite the fact that the investor holds the foreign securities through a Canadian ETF/MF. Note that when the investor is a non-resident of Canada, Canadian non-resident withholding tax applies, which represents a second layer of tax (see #5 below). 

Scenario B – Taxable account – Investor holds foreign securities indirectly through Canadian ETFs or MFs

  Flow of foreign income Incidence of foreign withholding tax 
1

Foreign securities
  • Foreign stocks and/or bonds are held by the Canadian ETF/MF

  • Note that Canadian-domiciled/resident securities (e.g., Canadian ETFs/MFs holding foreign securities) are not considered foreign securities
2 Foreign withholding tax on income
  • Investment income earned is subject to a foreign withholding tax at source

  • Foreign withholding tax may be reduced by way of tax treaty between Canada and the foreign securities' jurisdiction
3 Income paid to Canadian ETF/MF
  • Net amount (after foreign withholding tax) is paid to the Canadian ETF/MF

  • The Canadian ETF/MF will issue the foreign income to investors after accounting for expenses

4

 Foreign income issued to Canadian resident
  • If the investor is a non-resident of Canada, skip to #5 below

  • Net amount (after deducting foreign withholding tax and Canadian ETF/MF expenses) is paid to investors

  • Amounts received are reported on a Canadian tax slip with the total amount of foreign taxes paid and gross foreign income earned

  • A T3 tax slip is issued for Canadian ETFs/MFs that are trusts; a T5 tax slip is issued for ETFs/MFs that are corporations

  • The foreign tax credit may be used to reduce some of the foreign taxes paid on the Canadian income tax return

  • Foreign income is designated as "foreign non-business income" and foreign taxes paid are designated as "foreign non-business income taxes paid"
5 Foreign income issued to non-Canadian resident
  • A further layer of Canadian non-resident withholding tax applies to a non-Canadian-resident investor

  • The rate of Canadian non-resident withholding tax is 25% unless reduced by a tax treaty between Canada and the investor’s foreign-resident jurisdiction

  • Reduced treaty rates are generally only available if a completed NR301 form (or equivalent) is on file with the Canadian financial institution

  • An NR4 tax slip (instead of a T3/T5) is issued with a summary of the gross payments and total Canadian non-resident withholding taxes taken

In Scenario C, a Canadian-resident individual invests in a Canadian ETF/MF, which invests in a U.S-listed ETF. The U.S.-listed ETF itself invests directly in U.S. stocks and bonds. Effectively, there are two investment structures between the Canadian-resident investor and the underlying investments. Investment income generated and paid on the underlying U.S. securities will not be subject to U.S. withholding tax when paid to the U.S. ETF since they are both U.S. residents. It is only payment of investment income from the U.S. ETF to the Canadian ETF/MF that triggers U.S. withholding tax (the first layer of tax). The second layer of tax (Canadian non-resident withholding tax) only applies when distributions of income from the Canadian ETF/MF are issued to a non-resident of Canada (see #5 below). 

Scenario C – Taxable account – Investor holds Canadian ETFs or MFs that hold U.S.-listed ETFs with U.S. underlying securities

  Flow of foreign income Incidence of foreign withholding tax
1

Foreign securities
  • U.S. stocks and bonds are held by U.S.-listed ETFs

  • Canadian ETF/MF holds the U.S.-listed ETFs

  • Investor holds the Canadian ETF/MF
2 Income paid to U.S. ETF
  • Investment income earned is subject to a foreign withholding tax at source

  • Foreign withholding tax may be reduced by way of tax treaty between Canada and the foreign securities' jurisdiction
3 Income paid to Canadian ETF/MF
  • U.S. investment income paid to the Canadian ETF/MF is subject to the U.S. withholding tax at source; a distinction is made between qualified interest income (exempt from U.S. withholding tax) and dividends paid from U.S. stocks (subject to U.S. withholding tax)

  • Net amount (after U.S. withholding tax) is paid to the Canadian ETF/MF

  • The Canadian ETF/MF will issue the foreign income to the investors after accounting for expenses
4 Foreign income issued to Canadian resident
  • If the investor is a non-resident of Canada, skip to #5 below 

  • Net amount (after U.S. withholding tax and Canadian ETF/MF expenses) is paid to investors

  • Amounts received are reported on a tax slip with the total amount of U.S. taxes paid and U.S. income earned

  • A T3 tax slip is issued for Canadian ETFs/MFs that are trusts; a T5 tax slip is issued for ETFs/MFs that are corporations

  • The foreign tax credit may be used to reduce some of the foreign taxes paid on the Canadian income tax return
5 Foreign income issued to non-Canadian resident
  • A further layer of Canadian non-resident withholding tax applies to a non-Canadian-resident investor

  • The rate of Canadian non-resident withholding tax is 25% unless reduced by way of a tax treaty between Canada and the investor’s foreign-resident jurisdiction

  • An NR4 tax slip (instead of a T3/T5) is issued with a summary of the gross payments and total Canadian non-resident withholding taxes taken

Finally, in Scenario D, a Canadian-resident individual invests in a Canadian ETF/MF, which invests directly in a U.S-listed ETF. The U.S.-listed ETF itself invests in foreign securities and U.S. securities. Again, there are two investment structures between the Canadian-resident investor and the underlying investments. Investment income generated and paid on the underlying U.S. securities will not be subject to U.S. withholding tax when paid to the U.S. ETF. However, foreign withholding tax will apply on income paid from the underlying foreign securities (held outside the U.S.) to the U.S.-listed ETF. This is the first layer of tax. A second layer of withholding tax applies when investment income is paid from the U.S. ETF to the Canadian ETF/MF. This second layer of tax is the U.S. withholding tax. A third layer of tax (Canadian non-resident withholding tax) would only apply if the distribution of income from the Canadian ETF/MF is issued to a non-resident of Canada (see #6 below).

Scenario D – Taxable account – Investor holds Canadian ETFs/MFs that hold U.S.-listed ETF with underlying U.S. and foreign securities

  Flow of foreign income  Incidence of foreign withholding tax
1

U.S. & foreign securities
  • U.S. and foreign stocks and bonds (resident outside the U.S.) are held within the U.S.-listed ETF
2 Foreign income paid to U.S. ETF
  • First layer of withholding tax

  • Income paid on the underlying foreign securities (resident outside the U.S.) is subject to a foreign withholding tax; the rate of withholding is based on the foreign securities' jurisdiction and may be reduced by way of a tax treaty between that foreign jurisdiction and the U.S.
3 U.S.-sourced income paid to U.S. ETF
  • No withholding tax on investment income paid from the U.S. underlying securities to the U.S.-listed ETF since both are resident in the U.S.
4 Income paid to Canadian ETF/MF
  • Second layer of withholding tax 

  • Investment income paid to the Canadian ETF/MF is subject to the U.S. withholding tax at source; a distinction is made between qualified interest income (exempt from U.S. withholding tax) and dividends paid from U.S. stocks (subject to U.S. withholding tax) and applies on both the foreign investment income and the U.S.-sourced income earned within the U.S.-listed ETF

  • The net amount (after U.S. withholding tax) is paid to the Canadian ETF/MF

  • The Canadian ETF/MF will issue the foreign income to the investors after accounting for expenses
5 Foreign income issued to Canadian resident
  • If the investor is a non-resident of Canada, skip to #6 below

  • Net amount (after U.S. withholding tax and Canadian ETF/MF expenses) is paid to investors

  • Amounts received are reported on a Canadian tax slip with the total amount of foreign taxes paid and foreign income earned; foreign income is designated as "foreign non-business income" and foreign taxes withheld are designated as "foreign non-business income taxes paid"

  • A T3 tax slip is issued for Canadian ETFs/MFs that are trusts; a T5 tax slip is issued for ETFs/MFs that are corporations

  • The foreign tax credit may be used to reduce some of the foreign taxes paid on the Canadian income tax return
6 Foreign income issued to non-Canadian resident
  • Third layer of withholding tax: Canadian non-resident withholding tax (on income paid to a non-resident of Canada)

  • The rate of Canadian non-resident withholding tax is 25% unless reduced by way of a tax treaty between Canada and the investor’s foreign-resident jurisdiction

  • An NR4 tax slip (instead of a T3/T5) is issued with a summary of the gross payments and total Canadian non-resident withholding taxes taken

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