American Depository Receipts (ADRs) are a great way for investors to gain exposure to international and emerging market companies. Some of the most popular stocks in U.S. markets are ADRs. For instance, BP (BP ) and GlaxoSmithKline PLC (GSK ) are ADR stocks.
However, unlike traditional U.S.-based dividend paying stocks, ADRs can have a much more complex taxation method. If an investor is uninformed of the taxation of an ADR, it can erode the investor’s total return. So it makes sense to be aware of the taxation rules and avoid them, wherever possible.
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What Are ADRs?
One of the main principles of investing is to diversify, which means investing in several asset classes and investment types. In doing so, investors can spread out their risk and reduce volatility.
One way to increase diversification is to include international stocks. However, with the complexity of the U.S. tax code and various foreign tax codes, choosing an international stock can be a daunting task for the average investor. One way to purchase international stocks is through its ADR, which is simply a certificate issued by a U.S. bank that represents a certain number of shares of the foreign company. The ADR mirrors the price movements of the foreign equity as well as other features like dividend issuance. However, since the investor is actually buying a non-U.S. asset when they purchase an ADR, the tax structure gets complex.
To learn more about ADRs, read this article.
Taxation of Qualified or Eligible Dividends
Typically, when an investor receives a dividend payment from a stock, that income is taxed. Most stocks that pay dividends are considered ‘qualified’ under the U.S. tax code and therefore are taxed at a rate of 15% for investors that are in the 25% to 35% tax bracket. Investors below the 25% tax bracket are not taxed on dividends while investors in the highest 39.6% tax bracket are taxed at 20%. So, for example, an investor in the 28% tax bracket would be taxed $75.00 on a total dividend amount of $500.00, resulting in a net payout of 85%.
Canadian taxes on dividends are a little bit more complex according to the Canadian Revenue Agency (CRA). Typically, a gross up amount of 38% is factored into the original dividend amount. Then a federal dividend tax credit of 20.73% and a provincial tax credit of 13.8% (Ontario, for example) are subtracted from the income tax amount on the grossed up dividend figure. So in the same scenario with an investor that has a 35% combined marginal tax rate, a total dividend amount of $500.00 would be taxed $69.00 or 13.8%, leading to a net payout of 86.2%.
Follow our dedicated page on high-yield foreign dividend paying stocks.
Taxation of ADR Dividends
Like regular U.S.-based stocks, ADRs that issue dividends are taxed in the same manner. However, the one caveat is that because it is considered a foreign investment, the foreign home country will typically have a withholding amount. Each country has a different withholding tax but typically the amount ranges from 15% to 20%. Some countries have a significant amount of withholding on their dividends, such as Chile and Switzerland – both of which withhold 35%. France, for instance, also has one of the highest withholding rates in the world. The initial base rate is 30% but if the investor is in a non-cooperative country of the European Union, the rate is 75%.
Many countries around the world have set up tax treaties with the U.S. and Canada, which reduces the withholding rate for investors. Chile, Switzerland and France all have established tax treaties with both countries, so instead of the higher withholding rates listed above, U.S. and Canadian citizens only have to withhold a maximum of 15%. However, it is important to remember how ADRs work. ADRs are generally held in bulk by a foreign custodian, which may or may not have the residency information for each individual investor. In this scenario, the ADR custodian may reduce the dividend payment by the foreign domestic withholding tax.
To find a list of different tax treaties, click here.
Foreign Tax Credit
Typically, when a foreign country has withheld dividend taxes for an investor, the IRS or CRA will offer a tax credit so the dividend is not ‘double-taxed’. In the U.S., investors would have to fill out Form 1116 to claim the foreign tax credit that was already paid to the foreign country from which the dividend originates. This will offset the portion that was already taxed and therefore the U.S. taxpayer will only be taxed on the remaining portion. So if the tax treaty withholding rate was 15%, the U.S. taxpayer would not have to pay the 15% U.S. dividend tax rate.
One issue with ADRs is when the tax treaty rate is lower than the foreign country’s domestic withholding rate. Switzerland has a domestic foreign withholding rate of 35% and a 15% tax treaty withholding rate with the U.S. However, to qualify for the 15% tax treaty rate, investors must file paperwork with the Swiss government beforehand or be subject to the full 35%. If they do not do this ahead of time, the Swiss government will withhold 35% but the IRS will only give credit for the 15%. In this scenario, 20% is lost and can only be claimed if excess withholding tax-related paperwork is filed, which by itself is a cumbersome process.
ADRs should also be held in taxable accounts in both the U.S. and Canada, instead of in qualified or registered plans like an IRA or RRSP. Typically, tax-deferred accounts are great strategies for investors who do not have to worry about the tax implications of dividends. However, ADRs still require withholding, regardless of the type of account it is held in. So, it is important to note that when an ADR is held in a qualified or registered account, the account owner can no longer claim the foreign tax credit and the ability to claim will be lost.
To further customize your search for ADRs, you can use the Dividend Screener and search for stocks based upon 16 parameters. You can even screen stocks with DARS ratings above a certain threshold.
The Bottom Line
Overall, ADRs were designed to provide investors with access to international stocks without having to deal with foreign exchanges or currency. However, the taxation of ADR dividends is still complex. If an investor is interested in purchasing an ADR, it is important to first do the research on its dividend taxation. If the ADR’s home country has a tax treaty, be sure to first file the appropriate withholding paperwork.
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