Tuesday, 11 March 2014

How to Avoid the Misery of T1135 Foreign Holdings Disclosure

When we last wrote about the T1135 Foreign Income Verification Statement, the form required by the Canada Revenue Agency when certain specified foreign assets of a Canadian taxpayer exceed $100,000 in cost, things were complicated enough. Well, things have got worse. The CRA is now requiring a lot more detail on the foreign assets and the rules as to when exactly the detail is needed or not have become even trickier.

A selection of articles on the T1135 trauma

Investors may well cry out - help! how do I escape this? Below we offer some suggestions for equity ETFs that escape the CRA net yet still provide foreign holdings for a portfolio. But first we need to narrow the task.

Amidst all the complexity, a few things are clear: 
1) Most notably for the majority of taxpayer investors, is that holdings within registered plans like RRSPs and other forms of registered retirement plans - LIFs, RRIFs, LIRAs etc, TFSAs, and RESPs are exempt from the necessity to report on the T1135, no matter what their value. 

2) Apart from these exempt accounts, what matters is not the currency of the holding, nor whether the broker is Canadian or outside the country, nor the stock exchange where the investment is bought or sold. Canadian company bonds denominated in US dollars are still Canadian. Royal Bank stock traded on the NYSE is still Canadian. US company stock held in a taxable Canadian discount broker account is still foreign. 

What matters is the domicile of the security, where it is registered. A mutual fund or ETF registered in Canada that holds foreign bonds or equities is still Canadian. 

Equity ETFs that avoid the T1135 rigmarole
We've sifted through the various ETF providers, like iShares Canada, BMO Financial, Horizons and Vanguard Canada who create bonafide Canadian registered funds that cover the broad passive equity indices covering the USA, Developed countries and Emerging Market countries worldwide. There are certainly many other qualifying ETFs from other providers such as First Asset, RBC, Invesco Powershares - see them all listed here on TMX Money - but we focus on the mainstream basic non-currency hedged portfolio building block funds. 

In the comparison table below, the T1135-avoiding funds are in green text. The three funds we like best within each geographic category are highlighted in green background.
(click on image to enlarge)

Note that many of the Canadian substitutes for US-registered funds have higher MERs and as a consequence have a higher tracking error i.e. tend to under-perform their respective index by a greater amount. On the other hand Canadian registered funds offer some advantages that enhance net returns, such as:
  • automatic, free distribution reinvestment;
  • avoidance of the need to exchange foreign currency since the ETF trades in Canadian dollars and handles the exchange internally much more cheaply than an individual investor can achieve (though a couple of the ETFs, ZSP-U and HXS-U, trade in US dollars in Canada on the TSX, and would thus not confer that benefit)
We did a few calculations using our free ETF comparison tool and found that the combined effects of all factors often gave quite close to the same net return for the Canadian-based and the US-based funds.

Our three favorites are:
Though it has a higher total expense load due to the combination of the management fee and the swap fee, the deferral of any tax until the investor sells shares plus the transformation of what would be annual foreign income distributions into capital gains can be very attractive in a taxable account. A Horizons fact sheet shows the benefit through a simple example.

International Developed  / Europe Australasia Far East equities - BMO MSCI EAFE Index ETF (ZEA)
The fact that it has a) a competitive MER plus, b) recovery of international non-USA foreign withholding tax by directly holding the foreign equities that is lost when a Canadian ETF holds a US-based ETF inside, is what wins for this fund.

Emerging Market equities - BMO MSCI Emerging Markets Index ETF (ZEM)
The reasons are the same as for ZEA - competitive MER plus no loss of withholding tax.

It should be noted that this fix for needing to fill in the T1135, if a person now already has assets that breach the $100k floor for reporting, cannot work immediately for a 2013 tax return, or even for a 2014 return. It can only be effective starting in 2015, since the rule is that it is the cost at any time during the year that matters, not what may be there at the end of the year. 

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


Anonymous said...


Great post. But can you explain what you mean by:

b) recovery of international non-USA foreign withholding tax by directly the foreign equities that is lost when a Canadian ETF holds a US-based ETF inside


CanadianInvestor said...

Anon / SK,
You get a tax credit from the CRA on a Canadian tax return for foreign taxes levied by the various emerging market countries in a fund like ZEM, but in XEM you only get a tax credit for the US withholding taxes not for the foreign international withholding taxes levied before the dividends pass through the USA in EEM. Note that ZEM is not perfect in that regard, as almost half its holdings consist of US-based ETFs including EEM, along with country ETFs for Taiwan, Brazil, Poland, Turkey, Chile. see ZEM holdings here - http://www.etfs.bmo.com/bmo-etfs/holdings?fundId=72052

The Blunt Bean Counter said...

Great post CI

Thx for the links.

The transitional rules once the CRA clarified them are very helpful for 2013, the question is what happens next year. Investors should not even need to consider the T1135 reporting when deciding what ETFs and stocks to purchase.

CanadianInvestor said...

BBC, You are right it shouldn't need to be a factor but alas the hassle has got to the point that for some it could matter. Nevertheless, the ETFs need to be of equal or better quality on other dimensions, especially withholding taxes that eat away at returns.