Individual investors are often advised to keep 10-20% of their portfolios in foreign stocks, and these days that’s easy to do with a slew of mutual funds. But there’s a problem most investors don’t notice: Many countries require stock issuers to withhold taxes on dividends paid to Americans and other foreign shareholders.


For investors who hold foreign stock funds in taxable accounts, the withholding, typically 15% of the dividends paid, is merely an inconvenience, because an offsetting tax credit can be claimed on their U.S. federal income tax returns, says Wharton finance professor David K. Musto. “Where it becomes interesting is if this is a non-taxable account, particularly retirement savings.”


Since there is no tax credit or deduction for any kind of loss in a tax-deferred retirement account, there is no procedure for recovering the dividend withholding: It is lost for good. According to Musto, “Anyone who has retirement savings in a [foreign-stock] mutual fund has this problem.”


How significant is this loss, and how effective are the techniques money managers have devised to minimize it?


Musto and three colleagues examined those questions in a paper titled, The Limits to Dividend Arbitrage: Implications for Cross-Border Investment. His co-authors are Christopher C. Geczy, finance professor at Wharton; Susan E.K. Christoffersen, finance professor at McGill University; and Adam V. Reed, finance professor at the University of North Carolina.


For the average foreign stock, dividends are quite low. Annual dividends come to about 2.3% of stock prices. Since the tax withholding is just 15% of that, the tax reduces annual returns by only 0.35%, or 35 basis points, Musto and his colleagues found.


But the compounding effects can be much greater. Over a 30-year investment horizon, which is common for retirement accounts, this withholding would reduce the foreign-stock fund’s final value by 5%.


The largest international stock fund sold to U.S. investors, the $23 billion American Funds EuroPacific Growth Fund, reported $62 million in foreign dividend withholdings for the year ended March 31, 2003 – a loss of 27 basis points, the researchers found.

This issue is particularly important to fund managers trying to decide which foreign stocks to place in their portfolios, Musto said. If two stocks promise the same pre-tax return, the one providing that return through share-price increases rather than dividends will be preferable, from the perspective of investors holding the fund in tax-deferred accounts.


But investors who hold the fund in taxable accounts – and are thus able to recover the tax withholding – are ill-served if the fund manager passes up a good stock simply because it pays a large dividend.


Most funds are owned by both taxable and tax-deferred investors, whose interests conflict on this issue. This is no small problem. According to the Investment Company Institute, there was $358 billion under management in international equity funds at the end of 2002, with nearly half of that – $158 billion – held in tax-deferred retirement accounts.


Some fund managers have devised strategies to minimize the loss to foreign withholdings. Musto and his colleagues examined the effectiveness of these strategies by focusing on Canadian stocks bought by U.S. money managers.


Canadian companies are required to withhold for taxes 15% of dividends paid to non-Canadian shareholders, but they need make no withholding for Canadian shareholders. Some U.S. money managers have devised methods that, in effect, put their Canadian stocks into the hands of Canadians on the record date that determines which shareholder receives the dividends.


Stocks could be sold to Canadians and then repurchased after dividends are paid, but trading commissions could be larger than the savings realized from avoiding the tax withholding. Also, this could trigger a capital gains tax if the shares were sold at a profit, and the American fund could miss profits if the stock price were to rise during this brief period.


So money managers prefer a lending arrangement. Costs are low, there is no taxable event and the fund benefits from any price rise during the period the strategy is in effect.


While the principal is simple, it would be illegal to merely pretend to shift ownership of the shares to avoid tax. So the process is more complex.


An example in the paper assumes a U.S. mutual fund is due to receive $27,000 in dividends for 100,000 shares of TransCanada Pipeline owned by the fund. It would receive $22,950, while $4,050 would be withheld for taxes. To reduce that $4,050 figure, the fund would use this procedure:


·         Before the dividends are paid, the fund lends the 100,000 shares to an American arbitrageur.

·         The American arb uses the shares for a short sale to a Canadian arb before the dividend is paid. This way, the American arb does not own the shares when the dividend is paid. The American arb deposits in a financial institution the money it receives from the short sale to the Canadian arb. The American arb earns interest on the deposit.

·         The two arbs enter a swap agreement.

·         The Canadian arb receives the $27,000 dividend on the shares it has acquired in the short sale. It passes $22,950 of that to the American arb. This is the dividend minus the amount that would be withheld from an American shareholder. (The Canadian arb also pays the American arb an amount equal to any share price gain during this period, protecting the American arb from any loss on the short sale. Neither arb is to make or lose money on share-price changes.)

·         The American arb passes to the Canadian arb the interest earned on the short-sale proceeds, minus a discount.

·         The American arb passes to the fund the $22,950 received from the Canadian arb. The American arb also pays the fund a fee for the loan of the 100,000 shares.


As a result, the fund has received $22,950 in dividends – the $27,000 dividend minus the $4,050 tax withholding. In addition, it has received from the American arb the lending fee to offset part of the withholding.


The American arb earns an amount equal to the discount it kept when it passed the short-sale interest to the Canadian arb, minus the fee it paid the fund for the loan of the shares.


The Canadian arb has retained $4,050 of the $27,000 dividend. The Canadian arb has earned the $4,050 minus the discount on the interest it received from the American arb.“Effectively, the U.S. mutual fund is simply lending the shares to the Canadian arb, who won’t face a tax withholding,” Musto noted.


The short-sale and swap agreements have enabled the three parties to avoid the $4,050 tax withholding that the fund would otherwise face. The three have divided up the $4,050: the Canadian arb earns the $4,050 less the discount; the American arb earns the discount less the lending fee; the fund earns the lending fee.


Since the discount and the fee are negotiable, Musto and his colleagues wanted to determine how large they typically are.


To do that, they examined data from a large unnamed American financial institution which holds stocks in the accounts of American money managers. The researchers focused on Canadian stocks that are traded on American exchanges and are subject to the kinds of loans described above.


They found the technique was used in many cases to recover an average of two-thirds of the 15% withholding, minus a small amount for transaction costs. If a Canadian stock paid dividends equal to 1% of the share price, or 100 basis points, tax withholding would be 15 basis points. Arbitraging could recover 10 basis points, less 3 basis points for costs. So the fund would earn 92 of the 100 basis points instead of just 85.


While this technique benefits the “tax disadvantaged” investors subject to Canadian withholdings, it is not desirable for investors with taxable accounts. Since taxable investors can recover the withholdings when they file their U.S. tax returns, they would lose money through the lending fee and transaction costs incurred in the maneuver. Instead of receiving all 100 basis points of dividends in the example, they would get only 92.


Because of this, investors in foreign stock funds should look closely at fund materials to determine the effect of tax withholdings. Investors using taxable accounts can recover the withholding, and thus should avoid funds that must pass on the costs of lending strategies. Shareholders with tax-deferred accounts are better off with funds that avoid withholdings by spurning dividend-paying stocks, or which use lending strategies to offset withholdings.


“If you are retirement-investing, it certainly is wise to take a look at how much withholding tax there is in different international funds,” Musto suggested. “Withholding tax, from your perspective, is just money out the window.”