American depositary receipts

In short

A friend of mine once asked how a farmer in Ohio could own a piece of a company in Japan without ever opening a foreign bank account. The answer, more often than not, was an American depositary receipt. It is a certificate that trades on a U.S. exchange and stands in for shares of a foreign company. You buy and sell it in dollars, through the same brokerage account you already use. The company behind it still lives abroad, so its home country's rules, currency, and taxes still reach you. Before you act, find the ratio, the fees, and the withholding rate, and read each one for yourself. That small bit of homework tells you most of what the label does not.

The whole of it

What it is

I once watched a neighbor try to explain a foreign stock to his wife, and he finally gave up and said it was like a coat check ticket. He was closer than he knew. A bank in the United States, called the depositary bank, holds real shares of a foreign company in a vault overseas. Then it hands out receipts that stand for those shares. The receipt is the American depositary receipt, or ADR. It trades on a U.S. exchange or over the counter, and it is priced in dollars.

You have probably seen a few of these without noticing. Plenty of well known foreign companies have ADRs, and your brokerage screen shows them just like any other ticker. That ease is the whole point. The foreign company reaches American buyers, and the buyers skip the trouble of foreign markets.

One more piece of the puzzle matters. Each receipt may stand for one share, for half a share, or for ten shares. That fraction is called the ADR ratio. It is printed in the company's ADR documents, and it is the reason an ADR price can look very different from the price on the home exchange.

How it works

A friend of mine who works in banking once told me the plumbing is simpler than the name sounds. The foreign company, or sometimes just the market, sets up a program with a depositary bank. The bank buys or receives the foreign shares and keeps them with a custodian in the home country. Then it issues the receipts here at home.

When the company pays a dividend, it pays in its own currency. The depositary bank collects that money, changes it into dollars, takes out its fees, and passes the rest along to the holder. So the cash you get is never quite the cash the company declared. Currency swings and fees both nibble at it.

The receipts come in levels. Some are listed on a major U.S. exchange and must follow U.S. reporting rules, while others trade over the counter with far less paperwork. Sponsored programs involve the foreign company itself. Unsponsored ones are set up by a bank without the company's help. Each kind carries different amounts of public information, which is worth knowing before you hold one.

Voting also works a little differently. The holder of a receipt does not vote directly. The depositary bank usually passes along voting materials, and the holder may instruct the bank how to vote. The deposit agreement spells out how that goes.

The numbers, and where to find yours

If you are holding an ADR, or thinking about one, you have a short list of figures to track down. The first is the ADR ratio, and it sits in the program's documents and on the depositary bank's website. The second is the depositary fee. Banks commonly charge a small per share fee for services like handling dividends, and the deposit agreement states the exact amount.

The third is the foreign tax withheld on dividends. Many countries take a share of the dividend before it ever leaves home. The rate is set by that country's law and by any tax treaty with the United States. The IRS publishes a table of treaty rates in Publication 901, called U.S. Tax Treaties. The rate you may reclaim or credit is a legal figure, so check the current one rather than trusting memory. For a feel of how it looks on paper, picture a withholding rate of the current figure, which the official source publishes each year for one country and a different rate for another.

The fourth is the foreign tax credit. U.S. taxpayers can often claim a credit for foreign income tax already paid, and the IRS explains the rules in Publication 514, Foreign Tax Credit for Individuals. Your brokerage sends a Form 1099 DIV after the year ends, and it shows foreign tax paid in one of its boxes. Keep that form handy.

A worked example

Let me tell you about a woman named Marta Reyes, a schoolteacher in Tulsa who wanted a small stake in a European company. She found an ADR that trades in New York. Each ADR stands for 2 ordinary shares, and it costs $40 per ADR. She bought 50 ADRs.

First, the cost. 50 ADRs at $40 each is $2,000.

Next, the shares behind it. 50 ADRs at 2 shares each means she owns the economic value of 100 foreign shares.

Now the dividend. Suppose the company declares a dividend worth $1.20 per ordinary share at the exchange rate that day. Her 100 shares earn 100 times $1.20, which is $120.

The home country takes a withholding tax. Say that rate is 15 percent for this example. 15 percent of $120 is $18. That leaves $102.

The depositary bank then charges a fee. Suppose it is $0.02 per ADR. 50 ADRs at $0.02 is $1. That leaves $101 for Marta.

So she received $101 on a $120 dividend. She paid $18 in foreign tax and $1 in bank fees. The $18 of foreign tax may be claimed as a credit on her U.S. return, which can soften the sting. Marta kept her Form 1099 DIV and noted the $18 in the foreign tax box.

Every figure here is made up for the story. Her real numbers would come from her own ADR and her own statements.

Where it goes wrong

I have seen smart folks trip over three things. The first is currency. The ADR price is in dollars, but the company earns and spends in another currency. When that currency weakens against the dollar, the ADR can fall even if the company did fine at home. That is not a mistake by anyone. It is just how the arrangement works.

The second is the fees and taxes that shrink what lands in your account. Marta's $120 dividend became $101. Small leaks add up over years, and nobody sends a bill that says so. They simply come out of the payment.

The third is thin information. Some ADRs trade over the counter and share far less with the public than a company listed on a major U.S. exchange. Prices can jump around, and it can be hard to find a buyer when you want to sell. The SEC is the federal agency that oversees these markets, and its website is a fair place to start reading.

There is a fourth worry, and it is a quiet one. A foreign company follows its home country's laws, not ours. If a dispute comes up, a receipt holder's rights depend on the deposit agreement, the company's home country law, and the situation at hand. Those rights can differ from what a holder of a U.S. company has. The SEC's investor pages on foreign issuers explain more. Reading the deposit agreement is a plain first step.

Questions to answer before you leave this page

Do you know what the ADR ratio is for the one you are looking at, and have you checked it against the home market price? Have you found the depositary fee in the deposit agreement, and what does it come to on your number of ADRs? What is the withholding rate on dividends from that company's country, and have you looked it up in IRS Publication 901? Will your brokerage send a Form 1099 DIV that shows the foreign tax paid, and do you know where to find that box? Is the ADR listed on a major U.S. exchange or traded over the counter, and what does that tell you about how much the company must report? If the foreign currency drops against the dollar, are you comfortable with what that does to your holding? And have you read what the SEC publishes on its website about foreign companies, so that the plumbing no longer feels like a mystery?