Historically low interest rates have sent investors toward dividend stocks. To give one indication of how low yields are, at the end of 2013, the iShares Advantaged Canadian Bond Index Fund had a yield to maturity of 2.41% and duration of 8.2 years—not much better than a 5-year GIC at 2.20%. By contrast, the iShares S&P/TSX Dividend Aristocrats Fund yielded 3.37%.
And dividend payers are no longer considered stodgy. “You’ve got companies like Apple buying shares and distributing dividends,” notes Howard Atkinson, president of Horizons ETFs. “Gold stocks never used to have dividends and many are now paying [them] to make their equity more attractive.”
Indeed, the S&P/TSX Composite Dividend Index includes Barrick Gold, Suncor Energy, Potash and CNR among its top 10.
It’s a similar phenomenon across the globe. Mary Anne Wiley, managing director and head of iShares at BlackRock Canada, estimates 80% of the S&P 500 pays dividends. A decade ago it was 70%.
But lately, Canadian market returns have been lagging U.S. and European economies, which include many large-cap dividend payers. That’s one reason to look farther afield. Another? “When we look at the overall global dividend ETFs, Canada represents a very small sliver of that pie; in the neighbourhood of 2%,” says Wiley. How compelling are foreign dividends? As of November 2013, the BMO US Dividend ETF yields 3.71%, while the BMO Mid Federal Bond Index ETF (which includes mid-term Canadian bonds) had a weighted-average yield of 3.12%.
Similarly, the iShares 7-10 Year Treasury Bond ETF, based in the U.S., yields 1.83%, but the iShares Select Dividend ETF yields 3.3%, also based in the U.S.
To take a global perspective, the iShares Global Monthly Advantaged Dividend Index Fund yields 3.26% while the U.S. iShares International Select Dividend Index Fund yields 4.45%. That’s in comparison to the iShares International Treasury Bond ETF, again U.S.-based, which yields 1.63%.
But there’s a hitch to investing in foreign dividends. In Canada, dividends attract a tax credit to offset taxes paid out at the corporate level. But foreign dividends are taxed as ordinary income—rightly, since Canadian governments don’t tax foreign corporations and there’s no need to consider double taxation. Some companies have offshored themselves so there is little to no tax to pay at the corporate level.
There’s a second wrinkle. Other governments levy withholding taxes on dividends paid to foreigners. Typically it is 15%, but it could be higher. (Most countries, apart from the U.S., also levy withholding taxes on interest payments.) The Canada-U.S. Tax Treaty exempts registered accounts from dividend withholding taxes. That applies to RRSPs and LIRAs, among others, but not to TFSAs or RESPs. (For registered accounts, Canadians wouldn’t be able to claim a dividend tax credit anyway.)
In an open account, it’s more complex. Canadians can claim taxes withheld on their foreign income as a foreign tax credit to a maximum of 15%, explains Abby Kassar, a vice-president at RBC Wealth Management. But some countries, including India and Brazil, have higher withholding rates, and Canadians wouldn’t get a foreign tax credit for anything above 15%.
While Canadians aren’t likely to buy stocks on foreign exchanges, we can get exposure through American Depository Receipts (ADRs), which are foreign shares bundled for trading on U.S. exchanges by custodial banks. (Canadian stocks get around this procedure by simply interlisting on a U.S. exchange.) Mutual funds and ETFs alike use them for convenience.
But companies that sponsor the ADRs are still under the jurisdiction of the country in which they’re incorporated. As a result, “for a lot of these companies, foreign custodians do not actually know who the underlying owner is. So they may not know that they have a treaty with a Canadian owner or a treaty with a U.S. owner,” Kassar notes. The result may be higher-than-claimable withholding tax. (For a registered account, non-U.S. withholding taxes are not recoverable.)
Country of incorporation also matters. For instance, in an open account, a mutual fund will flow through dividends as foreign non-business income, but Canadians can claim a credit against that taxable income.
And ETF owners have a choice between funds domiciled in Canada and in the U.S. Many have been turning to U.S.-based funds because they don’t want the tracking error caused by currency hedging. They do, however, face currency conversion costs.
But it gets more complicated, explains Wiley. XSP, a Canadian wrap that invests in IVV, a U.S. ETF, has a trailing 12-month distribution yield of 1.50%; IVV has a distribution yield of 1.96%. The distribution yield includes both capital gains and dividends. For both funds, the capital gains distribution is a deadweight cost in an RRSP. So it’s a matter of computing the actual dividends paid.
In 2012, XSP distributed $1.05 per share. Of that, 31 cents was dividend income (the rest was capital gains and return of capital), and a 15% withholding tax would’ve represented a 0.05% tax drag (this didn’t reduce the actual distribution of $1.05). By contrast, IVV neither distributed capital gains nor returned capital in 2012, but paid out USD 77.8 cents a share in dividends.
Which investment comes out ahead? That’s tough to tell because the Canadian distribution structure may change, whereas the U.S. equivalent has consistently paid nothing but dividends. What this illustrates is the importance of tax allocation among accounts.
Regardless, there are other reasons to invest in a wrap rather than a U.S. ETF. It avoids complications over U.S. estate taxes, and U.S. taxes could take off 43 basis points, suggests research from RBC Wealth Management (see “Impact of excess withholding tax on ADRs”).
Taxes aside, argues Wiley, “income-starved investors are turning to dividend-paying stocks. And history shows the dividend and the reinvestment of the dividend is a strong contributor to the overall return.”
Jason Gibbs, a portfolio manager with Dynamic Funds, says about 50% of total returns come from dividend reinvestment. This year, Wiley adds, “in the U.S., the three-year total return was 57%. Of that, 47% was due to price appreciation and 10% was due to dividends.” In the 1990s, Gibbs notes, the contribution by dividends to total returns was negligible.
The time-varying contribution of dividends can be seen over the past decade. In the U.S., dividend reinvestment accounted for 90% of total returns over 10 years. Wiley adds, “in the U.S. [in 2013], the three-year total return was 57%. Of that, 47% was due to price appreciation and 10% was due to the dividends.”
The question is how sustainable those dividends are. Explains Gibbs: “Good dividend-paying stocks generate substantial free cash flow and tend to be oligopoly businesses with pricing power. They’re likely mature but they’re still growing.”
Table 1 Impact of excess witholding tax on ADRs
|Issuer||Country of Origin||Price||Dividend||Actual Witholding Tax Rate||Treaty Withholding Tax Rate||Excess Withholding Tax Rate||Relative Underperformance|
Source: RBC Wealth Management Services