A reader recently suggested an article on strategies – and tax consequences – for Canadians wishing to invest in U.S. securities.
A number of avenues are available for the purchase of U.S. securities. They can, for instance, be bought directly on U.S. exchanges using Canadian funds. Since this will result in significant exchange-rate conversion costs, it is not recommended. Or, an investor may have a U.S. investment account in which U.S. funds are held and invested, thereby avoiding such conversion costs. Or most simply, an investor can purchase U.S. securities using Exchange-Traded Funds, Index Funds, or Mutual Funds – all available on Canadian financial markets – thus avoiding currency-conversion costs.
Should any of these investment approaches be taken within a Canadian RRSP or RRIF investment framework, we need not worry about tax implications, Canadian or U.S., resulting from dividends, interest, or capital gains.
However, should the U.S. investment be held in a non-registered investment account, all U.S. dividends paid into the account will be subject to a U.S. 15 per cent withholding tax, deducted before the net dividend is deposited in the account.
Earned interest and capital gains however, are not subject to this withholding tax.
Fortunately for Canadian investors, a Canada-U.S. tax treaty results in a Canada Revenue Agency “credit” for tax withheld on U.S. dividends – effectively neutralizing the tax impact. Both the amount withheld and the credit will be shown on the investor’s year-end tax statements.
While the tax issue is essentially a wash for the Canadian investor holding U.S. securities, the same cannot be said for the ongoing financial risk associated with currency value fluctuations, particularly between Canadian and U.S. dollars. When a Canadian purchases a U.S. security, he becomes subject, in addition to normal market risk, to an additional level of risk – exchange-rate risk.
For example: A security, purchased for U.S. $100, grew in value by five per cent, to $105.
The Canadian investor may gain more or less than this amount, or even lose money, due to changes in relative currency value since the purchase was made. In this case, if the U.S. dollar had strengthened, the Canadian equivalent gain would be greater than five per cent. Had the U.S. dollar weakened, as has generally occurred over the past number of years, the gain would be less, perhaps even a loss.
To avoid foreign-exchange risk on U.S. investments, Canadian investors can purchase currency-hedged products which are available on some ETFs, Index Funds and Mutual Funds. Currency hedging is not available for individual U.S. stocks. By holding U.S investments on a hedged basis, the investor’s risk is limited to only normal market risk.
Hedging foreign purchases is a particularly important risk-reducing strategy when investing in only one country’s securities – such as in our U.S. example. When multiple countries, and hence currencies, are encompassed in a purchase, currency risk diminishes as a factor.
For example, a Canadian purchasing a Global Real Estate ETF with hundreds of constituent company holdings in perhaps 20 countries, encounters much less currency risk, even without hedging. The reason is simple – across the entire basket of holdings, some currencies will rise while others decline, thus moderating the impact of currency swings.
Keep this in mind – always consult with your own accountant and financial advisor, to ensure that you are fully informed of the various consequences of investing in foreign securities.
Although this article has touched on the main issues, they should be fully explored and understood before an investor proceeds with a purchase of securities outside Canada.
A retired corporate executive, enjoying post-retirement as a financial consultant, Peter Dolezal is the author of three books. His most recent, the Smart Canadian Wealth-Builder, is now available at Tanner’s Books, and in other bookstores.