Q.) I hold U.S. investments in my self-directed RRSP and have just found out that a 30% tax has been withheld from interest and dividend income received from U.S. companies. Why should I be paying U.S. taxes and how can I get it back? I'll pay taxes again when I receive my RRSP income. I'm sure a lot of Canadians hold U.S. investments and don't know how this works.

A.) You are right. Over 750,000 Canadians hold U.S. investments directly or through a registered account. The Canada/U.S. tax agreement allows for tax to be withheld by the paying country on dividends and interests paid to residents of the other country. But the parties have agreed that rather than applying the 25% to 30% withholding tax rate imposed for residents of non-tax treaty countries, that lesser withholding tax rates will apply. Where the securities owner has certified that he or she is a Canadian resident, the U.S. disbursing agent will withhold the reduced rate of 10% for interest income and 15% for dividends payable to a Canadian resident or a Canadian resident's account.

For personal accounts, the Canadian then includes the grossed-up amount (100% of the interest or dividend payment) on Canadian tax returns, and calculates federal and provincial taxes in the normal way. Then the taxpayer may claim a reduction of income tax, because of the U.S. tax withheld when the dividend or interest was paid out. In this way, the aggregate tax is no greater than what he or she would otherwise pay, unless the recipient did not have to pay taxes in the first place.

If the taxpayer has not certified that he or she is a Canadian resident using the U.S. form W-8, then the paying institution will automatically withhold 30% withholding tax.

On filing the Canadian returns, the individual will find that the foreign tax credit claimed will only be allowed to the level of the normal 10% to 15% withholding tax level. In this case, the aggregate tax paid, consisting of the federal and provincial tax plus the 30% U.S. withholding tax, will exceed the amount a Canadian would normally pay, giving rise to some double taxation.

That's why individuals should make sure that the foreign disbursing agent is well aware they are Canadian residents.

Another punitive situation arises when the U.S. security is owned by an RRSP or RRIF account. No annual Canadian tax returns are filed because the investment income is not taxed as it is received. In subsequent years, the whole of the amount paid out of such a registered account is subject to taxation. And because this income is separately defined in the Income Tax Act, it does not qualify as investment income from a foreign source.

Bylo's note: According to RRSP or RRIF Holding U.S. Stocks:

If your RRSP or RRIF holds [U.S.] stocks and they pay dividends, you should be aware of tax relief which is available through the Canada-U.S. tax treaty.

Normally, when a U.S. corporation pays dividends on its shares to a non-U.S. resident, a withholding tax of 30% must be withheld and remitted to the IRS. For Canadian residents, this tax is reduced by the Canada-U.S. tax treaty to 15% (5% in some cases where the shareholder is a corporation).

However, the Canada-U.S. tax treaty makes an RRSP or RRIF entirely exempt from U.S. taxes. This is because an RRSP or RRIF is "a trust, company, organization or other arrangement that is a resident of Canada, exempt from income tax in Canada and operated exclusively to administer or provide pension, retirement or employee benefits".

Because the RRSP or RRIF is exempt, no U.S. withholding tax can apply. However, the U.S. corporation paying the dividend generally will not know about this exemption until it is pointed out.

You should therefore ask the trustee of your RRSP or RRIF to notify the U.S. companies in which it holds stock of this provision in the tax treaty. Once such notification is received by a U.S. company, no U.S. tax should be withheld from any future payments of dividends by that company.

So no income tax credit can be received with respect to U.S. taxes withheld on interest or dividends paid to the Canadian registered account.

This makes it even more important that the disbursing agent be made aware that the account is owned by a Canadian resident. Then the lower withholding tax rates of 10% and 15% will apply.

There is no way to avoid these taxes withheld but at least you can keep them to the legal minimum, and take some comfort in the fact that your registered funds will eventually be taxable in Canada and the part taken by the U.S. government cannot be taxed again.

Still, these U.S. withholding taxes grind away at your investment income, so you will want to check the details of investment returns for your registered accounts to ensure that the lower withholding tax is withheld.

The same thing can happen in the United Kingdom and elsewhere. The agreement with the U.K. calls for taxes to be withheld but allows the Canadian recipient to claim back the taxes provided he or she can prove that they paid tax on this income in Canada. Refunds are not permitted for RRSP and RRIF accounts because they do not file tax returns annually.

You will be smart to arrange your investments to avoid a situation where withholding taxes are imposed, if at all possible. This shouldn't stop you from making foreign investments with your registered funds, but should alert you to consider these taxes and to keep them to a minimum.

I wouldn't give up investing in fine foreign companies that will give you substantial investment growth just because withholding tax applies to the small annual dividends. But you should keep an eye on fixed-income investments to ensure that they are either exempt of withholding tax, or obtain equivalent investments without going outside of Canada. And think about selling shares of foreign companies that will pay high special dividends as part of a corporate reorganization.

Robert Kerr, CA, CFP, RFP, is chairman of Kerr Financial Corp., a national tax and investment advisory firm. Send your questions on personal finance topics by e-mail to www.kerrfinancial.ca, by fax to (416) 383-2443 or by mail to Money Q&A, FP Investing, 300-1450 Don Mills Rd., Toronto, Ont. M3B 3R5. This column cannot comment on specific securities and portfolios or provide personal replies.