The ins and outs of foreign withholding taxes

Usually, U.S. withholding tax applied on foreigners is 30% of the value of the dividend. But under the Canada/U.S. tax treaty, Canadians can have that tax reduced to 15%. For example, if a Canadian received US$100 in the form of a dividend from a U.S. company, the company would hold back $15 to remit to the U.S. government.

There is an important feature of the withholding tax that needs to be kept firmly in mind: it is a “final” tax — there’s no way for the inves-tor to get the money back after it has been remitted to the U.S. government. In addition, foreign dividends, including dividends on U.S. shares, are not eligible for the Canadian dividend tax credit; foreign-source dividends are taxed at the full marginal tax rates in Canada.

Fortunately, Canadian inves-tors do receive a foreign tax credit from the Canada Revenue Agency for the withholding tax paid. This goes a considerable way toward eliminating the potential problem of double taxation on dividends received from U.S. companies.

Jamie Golombek, managing director of tax and estate planning with Canadian Imperial Bank of Commerce’s private wealth-management division in Toronto, explains how the withholding tax operates: “If your Canadian marginal tax rate is, let’s say, 45%, and you’ve already paid 15% in withholding, you’d get credit for the 15%, and would pay only the difference of 30% [on your Canadian tax return].”

In general, under U.S. tax law, there are no withholding taxes imposed by the U.S. on the interest earned by a Canadian from a U.S. investment. However, that interest income is taxable in Canada. As well, any capital gains on the sale of the U.S. asset would be taxable in Canada only under the capital gains rules that apply within Canada.

The tax treaty rate does not apply automatically, however, and an extra step is required. In this case, the Canadian taxpayer must ensure that they have filed U.S. Form W-8BEN with the U.S. company in which they’ve invested.

“Your broker would be required to get that form from you,” says Ryan Carey, a cross-border tax advisor in Toronto. “[On] that form, you’re stating that you are a Canadian resident and you are eligible for the reduced taxes under the treaty.”

The W-8BEN is usually obtained when the Canadian shareholder first buys the security. It’s very important that the W-8BEN be processed before any dividend payments are received from the U.S. company.

Failure to do this will result in a much bigger hit in terms of the withholding taxes. That’s because, without the form, the U.S. company will hold back 30% rather than the tax treaty rate of 15%.

The consequences of this failure are further headaches and delays. Explains Tannis Dawson, senior specialist in the tax and estate planning department of Investors Group Inc. in Winnipeg: “The only way to get that money back is to file a U.S. tax return, and that’s expensive and time-consuming.”

Filing a U.S. return also involves applying for a U.S. individual tax identification number, which represents yet another administrative disincentive. In fact, many people simply don’t like the idea of being flagged in this way by the U.S. Internal Revenue Service. Says Carey: “Many people say, ‘Well, I’m a Canadian, and I don’t want the IRS having a number for me,’ so they elect not to do it.”

How the U.S. security is held is also key. There is a significant advantage in holding such investments inside an RRSP or a RRIF that is administered by a Canadian financial services company. The dividends from a U.S. security that is held in these types of accounts automatically receive the tax treaty exemption from U.S. withholding taxes.@page_break@Another point to remember: this favourable treatment for Canadian registered accounts is only for U.S. securities; it is not available for dividends from shares in companies from foreign countries that are not based in the U.S.

“To the best of my knowledge, there is no exemption of withholding taxes on dividends paid to RRSPs or RRIFs in any other [tax] treaty,” Golombek says. “You can face a high rate of withholding tax, depending on the country, if it’s not the U.S. — and that’s non-recoverable. So, on a $100 dividend, you might lose, say, 25%. The result would be that only $75 would go into your RRSP.”

There are other landmines. The exemption available to dividends paid on U.S. stocks held in RRSPs or RRIFs does not apply to TFSAs: quite a few Canadian investors have already been tripped up by this, perhaps due to the fact that the TFSA is relatively new.

“If you hold U.S. shares in a TFSA, you’re going to lose 15% of any dividends paid to you,” Golombek cautions. “And that’s a permanent loss, because, since it’s in a [non-exempt] registered account, you can’t claim the foreign tax credit.”

The exemption also does not apply to RESPs or registered disability savings plan. The only registered accounts to benefit from the treaty exemption on dividends from U.S. shares are RRSPs and RRIFs.

This varying tax treatment of U.S.-source dividends among registered retirement accounts, TFSAs, other registered accounts and non-registered accounts will have an effect on your clients’ choices when it comes to U.S. investments.

In most cases, U.S. dividend-paying shares would seem to be best held in RRSPs. There may, however, be good reasons to hold them in TFSAs anyway, depending on a client’s individual situation — and especially if he or she is in the top tax bracket.

“It depends on an investor’s circumstances,” Dawson says. “Often, it still does make sense to hold U.S. shares in a TFSA, even though you’re going to get tax withheld on it, because the [capital gains] growth in a TFSA is tax-free vs 50% taxable when held in a non-registered account.”

Another point of confusion is the treatment of dividends from American depository receipts, which trade on U.S. stock exchanges but aren’t, in fact, shares in U.S. companies. For tax purposes ADRs, which are issued by U.S. banks, represent an interest in shares of foreign, non-U.S. companies.

As such, ADRs can represent a double threat from a tax perspective. “ADRs do not qualify for the U.S. withholding rate, so the withholding might not be 15%. It might be substantially higher,” Golombek says. “Because [ADRs] are not considered shares of a U.S. company, they don’t fall under the Canada/U.S. tax treaty.”

Another problem Canadian investors dipping into the U.S. market can run into occurs when they invest in small U.S. companies, private businesses and private partnerships. Quite often, these small U.S.-based firms have little or no experience when it comes to dealing with foreign investors, from any country, and will not be aware of their obligation to withhold the appropriate amount of tax on dividends or other distributions that are paid out to Canadian investors.

Says Carey: “There’s a pretty good chance that neither the U.S. business owner nor their tax advi-sor knows anything about the withholding rules surrounding foreign investors.”

Lack of awareness that goes on for years can lead to some unpleasant surprises. “When a Canadian who has invested in one of these things for a few years comes in to see me,” Carey says, “we often have to tell him or her that they have a massive U.S. tax liability, including penalties and interest, because the U.S. company didn’t do the withholding.”

Someone who found themselves in this situation would either have to pay the liability immediately or negotiate an instalment plan with the IRS.

Income from partnerships engaged in business is treated as ordinary income rather than dividends, Carey says. Canadians who invest in U.S. partnerships not only are liable for withholding taxes at the individual tax rate in the U.S., but there’s also an obligation to file a U.S. tax return every year.

Canadians who decide to invest in small U.S. firms, businesses and partnerships need to be proactive about knowing they have a U.S. tax liability. Says Carey: “You want to reach out to a cross-border U.S. tax advisor and at least make sure that you’re doing things in a tax-efficient manner and you know your obligations.”

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