The tax issue created by Canadian ETFs that simply hold ETFs trading in the US is seldom discussed but the additional tax drag is worth highlighting. Take for instance, the iShares CDN MSCI EAFE ETF (XIN), which holds the iShares MSCI EAFE Index Fund (EFA). EFA holds foreign stocks that trade in the UK, Japan, Germany, Australia etc. but the fund itself is located in the US. Therefore, EFA pays a withholding tax on dividends according to the tax treaty between the US and whichever country the company paying the dividend is resident of. Since, XIN simply holds EFA but is listed in Canada, XIN will pay a further 15% withholding tax to the IRS before paying the dividends to Canadian investors. In taxable accounts, this is not a problem because the dividends received through XIN are taxable anyway and Canadian taxpayers will receive a credit for foreign taxes paid.
There is a problem, however, with holding XIN within a RRSP account. The withholding tax paid to the IRS by XIN is not recoverable and creates an additional tax drag. If we assume a 3% dividend yield on EFA, the 15% withholding tax creates an extra tag drag of 0.45% for holding XIN over EFA within a RRSP.
The extra tax drag is not limited to Canadian ETFs that hold US-listed ETFs that hold foreign stocks. It also applies to Canadian ETFs that hold US-listed ETFs that hold US stocks such as the iShares CDN S&P 500 ETF (XSP). Another example is the recently launched Claymore Emerging Markets ETF (CWO), which simply holds the Vanguard Emerging Markets ETF (VWO). It is probably cheaper for ETF vendors to structure Canadian ETFs to hold US ETFs but the withholding tax creates an additional tax drag that is borne by the investor.
Bottom line: If a Canadian ETF simply holds a US-listed ETF, an additional tax drag is created due to withholding taxes that are not recoverable when the ETF is held within a RRSP account. It may be cheaper, instead, to simply hold the US-listed ETF directly.
