Don’t sweat the withholding tax on U.S. ETFs, and keep your tech in check

I own the BMO S&P 500 Index ETF (ZSP) in my registered retirement income fund and tax-free savings account. Can you explain the withholding tax implications of holding ZSP in these accounts and whether there is a better way to get exposure to U.S. stocks?
It’s a bit complicated, but I’ll try to make the explanation as straightforward as possible.
If you own a Canadian-listed exchange-traded fund such as ZSP that invests in U.S. stocks, the ETF will be subject to a 15-per-cent U.S. withholding tax on the U.S. dividends paid to it by the underlying companies. The withholding tax applies regardless of the type of account – registered or non-registered – in which you hold the Canadian-listed U.S. equity ETF.
Canadian investors can avoid withholding tax on U.S. dividends by investing in U.S. stocks directly or through a U.S.-listed ETF. However, to qualify for a withholding tax exemption under the Canada-U.S. tax treaty, the U.S.-listed stocks or ETF must be held in a RRIF, registered retirement savings plan or other account that specifically provides retirement or pension income. (Sorry, a TFSA doesn’t count.)
Still, investing in U.S.-listed ETFs or individual U.S. stocks has its own drawbacks. Unless you already have sufficient U.S. cash on hand, you’ll need to convert your Canadian dollars into U.S. dollars to make the purchase. This can be expensive, as brokers typically charge exchange rates that could cost you 1.5 per cent or more on each transaction.
When I checked with my broker on Friday, for example, converting $10,000 into U.S. dollars, then back into Canadian dollars, would have cost about $315, or more than 3 per cent of the principal amount. That’s a hefty price to pay just for currency transaction costs.
Most Canadian-listed U.S. ETFs, on the other hand, trade in Canadian dollars, eliminating the need for investors to purchase U.S. dollars. The ETF itself handles currency conversions to purchase U.S. shares, but the costs aren’t nearly as onerous because ETF companies deal with large sums of money and get access to institutional exchange rates not available to the general public.
It’s also important to keep the withholding tax issue in perspective. The S&P 500 Index currently yields just 1.4 per cent. Subtracting withholding tax of 15 per cent would reduce the net yield to about 1.2 per cent – a loss of about 0.2 percentage points.
That’s not a big deal. Based on a $10,000 investment in ZSP, the annual drag from withholding tax would be about $20. At that rate, it would take about 15 years for the accumulated withholding tax to equal the currency transaction costs for buying and selling a U.S.-listed ETF that is not subject to withholding tax in a retirement account.
Bottom line: Don’t let a small amount of withholding tax stop you from investing in a Canadian-listed S&P 500 ETF and holding it in your RRSP, RRIF, TFSA or any other account.
I own the Vanguard S&P 500 Index ETF (VFV). Is there a reason you like ZSP over VFV?
No. All the major ETF companies offer S&P 500 funds, and they are virtually identical in terms of their holdings, cost and performance. VFV’s annualized total return for the five years through March 31 was 14.95 per cent, compared with 14.97 per cent for ZSP and 14.94 per cent for the iShares Core S&P 500 Index ETF XUS-T. These differences are so small as to be meaningless. All three of these ETFs also have identical management expense ratios of 0.09 per cent, which means only a sliver of your money will go toward fees.
Keep in mind that ETF companies also offer currency-hedged versions of their S&P 500 funds for investors who want to be protected in the event of a sharp rise in the Canadian dollar. The downside is that, if the Canadian dollar falls, currency-hedged ETFs won’t get the same benefit as non-hedged ETFs. Also be aware that hedging is not an exact science, so the returns of a currency-neutral ETF might still differ from the returns of the U.S. index it tracks.
Would you consider the TD Global Technology Leaders Index ETF (TEC)? Since the prices of the Magnificent Seven stocks are now beyond my means, this looks like a good way to participate. Maybe there are some drawbacks I don’t know about?
TEC has some attractive attributes. It’s well-diversified, with 246 holdings, including the Magnificent Seven stocks – namely, Microsoft Corp. MSFT-Q, Apple Inc. AAPL-Q, Nvidia Corp. NVDA-Q, Amazon.com Inc. AMZN-Q, Meta Platforms Inc. META-Q, Alphabet Inc. GOOGL-Q and Tesla Inc. TSLA-Q. TEC’s management expense ratio is reasonable at 0.39 per cent, which is identical to the MER of another Canadian-listed tech-focused fund, the BMO Nasdaq 100 Equity Index ETF ZNQ-T. Both ETFs also have currency-hedged versions, which trade under the symbols TECX and ZQQ, respectively.
Despite TEC having more than twice as many holdings as ZNQ, there is a lot of overlap between the funds, which explains why their returns have been similar. For the year ended March 31, TEC posted a total return of 42.2 per cent, and ZNQ gained 39.3 per cent. These returns include dividends, which are not much of a factor as both ETFs yield less than 1 per cent.
But I can’t stress this enough: Don’t go overboard with technology stocks. Many of these companies have already had tremendous runs, and some, such as Tesla and Apple, have been struggling lately. Even AI darling Nvidia is down nearly 10 per cent from its record high a month ago. With many tech companies still trading at rich price-to-earnings multiples, the stocks are vulnerable if their growth disappoints. So, by all means invest in tech, but remember to do so as part of a well-diversified portfolio that suits your risk tolerance. Remember, too, that if you hold an S&P 500 ETF, you may already be getting all the tech exposure you need, as the Magnificent Seven account for nearly 30 per cent of the index.
E-mail your questions to [email protected]. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.