When Investments, Tax Planning, & Financial Planning collide

I was pitched an investment solution from a niche ETF provider in the USA while I was at Wealth Management EDGE . Because ETF's can be "bought" across the border - these discussions come up from time to time. What follows is an example of how you need to be thinking about how investment strategies and tax planning intersect.

The investment strategy (simplified explanation) basically takes 2 asset classes: USA dividend paying securities & USA bonds and wraps it together in a balanced style portfolio. The focus on using these two asset classes is that with higher interest rates - advisors and their clients with a focus on income might be interested in a product like this that is somewhat stable with a decent amount of income. The stated distribution was about 7% (not a ton of cap gains expectation).

This is incredibly tax inefficient in most accounts. I will explain.

The best part - their pitch to me started with "20% of our inbound inquiries are from Canadian Advisors". Turns out these 20% haven't explored how the taxes work on these items.

To quickly explain:

When international companies pay a dividend - in non-registered accounts it's treated as "foreign income" which is fully taxed like personal income. Additionally it is often subject to witholding tax at the home country. USA withholds 15% on taxable distributions from funds as an example.

USA Bonds are a tad different - in most cases the interest income will not be subject foreign withholding tax - however it will be fully taxable to the investor depending on the account.

While I don't know the actual breakdown of where the returns are coming from - let's presume the return if 50% interest income and 50% dividends.

So 3.5% USA dividends and 3.5% Interest Income. What would the after tax income look like?

RRSP: There is no foreign with-holding tax (due to the tax treaty) on USA ETF's holding USA securities in an RRSP and investments are taxed on withdrawal. only Total investment return - 7%.

TFSA: Unrecoverable foreign withholding tax will apply to the dividends. Because it's unrecoverable in a TFSA it functions as a true tax. 3.5% * 0.15%= 0.525% tax drag. 7% - 0.525%=6.475%.

Non Registered portfolio: The Foreign Withholding tax will come back (you get a credit for it in non-registered accounts) but all 7% is technically taxable based on the way this investment strategy was described. That means the after tax return in Canada is:

at 29.65%: 4.9245%

At 43.41%: 3.9613%

At 53.53%: 3.2529%

The after tax return and the rate of compounding is a lot lower than it would be in a comparable portfolio that included returns from Capital gains, eligible dividends, or deferred capital gains all of which are taxed at lower rates (and often found a low cost, index based, diversified portfolio).

This is one example how an understanding of tax planning and investment strategy both are necessary for the complete picture in a wealth projection.