Yahoo Finance FP Answers: Are Canadian depositary receipts safe for a retirement portfolio?
In an increasingly complex world, the Financial Post should be the first place you look for answers. Our FP Answers initiative puts readers in the driver’s seat: you submit questions and our reporters find answers not just for you, but for all our readers. Today, we answer a question from Randy about Canadian depositary receipts.
By Julie Cazzin with Andrew Dobson
Q: Canadian depositary receipts (CDRs) are being advertised for sale and I wonder how safe they are for a retirement portfolio? Secondly, why aren’t their dividends the same as the dividends from the parent company in the United States? Finally, how are these taxed if I hold them outside my registered retirement savings plan (RRSP)? — Thank you, Randy
FP Answers: CDRs were introduced in 2021 and enable an investor to buy U.S. stocks in Canadian dollars on a Canadian stock exchange. CDRs are based on a concept that has existed for almost 100 years in the U.S. called American depositary receipts (ADRs).
There are now more than 2,000 ADRs listed in the U.S., representing companies from more than 70 countries. The Canadian CDR market is relatively small, with 30 U.S. stocks available to investors on the Neo Exchange, but includes some of the biggest U.S. stocks on the New York Stock Exchange (NYSE) and Nasdaq.
Depositary receipts represent direct ownership in shares of companies that are listed on other foreign stock exchanges. As there are significant costs and logistical barriers for investors to access markets other than their home market, these investments provide international diversification outside of using managed products such as mutual funds or exchange-traded funds.
One of the benefits of these products is that they allow investors to buy shares of companies at a fraction of the primary listing price. Investors can purchase fractional shares of the U.S. company expressed in Canadian dollars. For example, Amazon.com Inc. CDRs first opened at $20 Canadian a share in August 2021. At that time, Amazon’s common shares were trading on the NYSE for about US$173.
CDRs are currency hedged, Randy, meaning they do not fluctuate with changes in the exchange rate between Canadian and U.S. dollars. If the U.S. stock your CDR tracks goes up five per cent, it goes up five per cent, regardless of what happened with the foreign exchange rate.
The key concept behind the pricing of a CDR is the CDR ratio, which calculates how many shares an investor owns factoring in currency conversion. The issuing institution earns a spread on the currency conversion required to convert Canadian dollars to U.S. dollars when the CDRs are purchased.
If an investor converts Canadian dollars to U.S. dollars to purchase U.S.-listed securities, you are effectively locking in your exchange rate at that time. Your return may rise or fall with the U.S. dollar. Some investors, including the Canada Pension Plan Investment Board (CPPIB), have argued against currency hedging. You are potentially limiting the diversification benefits of owning foreign currencies when all your returns are in Canadian dollars, as they are with a CDR.
According to the CPPIB, “hedging foreign equity returns tends to increase, rather than reduce, overall return volatility for a Canadian global investor. The Canadian dollar tends to strengthen when global equity markets are rising and weaken when they are falling. This is partly due to the Canadian dollar’s status as a commodity currency.”
From a general risk management perspective, the same risks apply whether you buy a CDR or the U.S. stock directly, since there is no difference in the fundamental aspects of the company. Because the CDR share prices are low, an investor can buy many different CDRs to ensure proper diversification.
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The reason the CDR dividends are different from the underlying stock is based on the CDR ratio. If one CDR share of XYZ Co. trades for $20 in Canada, and XYZ shares trade for US$100 on its primary U.S. exchange, then one share of a CDR and one share of a stock do not hold the same ownership of the company.
If the US$100 company in the U.S. pays a US$4 dividend, the $20 CDR in Canada would pay an 80-cent dividend, which is still four per cent. Dividend yields on the CDR and primary listing should be identical when expressed as a percentage, even though the dollar amount may differ.
CDR dividends are considered foreign income for tax purposes. Dividends from a U.S.-based CDR are not subject to withholding tax in an RRSP. However, U.S.-based CDR dividends are subject to 15-per-cent withholding tax in a tax-free savings account or registered education savings plan. If a CDR tracks a non-U.S. company, the dividends will be subject to the withholding tax, regardless of the account, generally at 15 to 25 per cent.
If you hold CDRs in a taxable non-registered account, foreign tax is generally eligible to claim as a foreign tax credit, which would avoid double taxation. For example, if you had 15-per-cent tax withheld and you were in a 30-per-cent tax bracket, you would only pay the incremental 15-per-cent tax owing on the dividend, thereby getting credit for tax already withheld.
There can be significant benefits to investing internationally, specifically diversification into different sectors, economies and market capitalization. CDRs are one way for investors to access U.S. stocks as part of their investment strategy. If the U.S. ADR market is any indication, Canadian investors can expect to see the number of U.S. stocks listed in Canada grow, and the introduction of other international stocks as well.
Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc. in London, Ont. He does not sell any financial products whatsoever. He can be reached at adobson@objectivecfp.com.
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