What is an American Depositary Receipt (ADR)?
An American depository receipt is a negotiable certificate issued by the United States depositary bank that represents one or more shares of a foreign company’s stock. ADRs allow American investors to trade foreign company stocks on U.S. stock exchanges.
Companies prefer ADRs because they can get American investors and capital without listing them on the U.S. stock exchange.
How do ADRs work?
ADRs are traded only in U.S. dollars. An American bank first buys the foreign stocks on the foreign exchange where they are listed. The bank then issues an ADR for each stock it holds. One ADR may be equal to one share or more. The bank issuing the ADR also gets detailed information about the companies so that American investors can access it. ADRs are listed on either the New York Stock Exchange (NYSE) or the Nasdaq. They can also be traded over the counter.
Types of ADRs
There are two types of ADRs: sponsored and unsponsored.
Sponsored ADRs: An American bank and a foreign company enter into a legal agreement and the sponsored ADR is created cooperatively. It is called a sponsored ADR because the company whose shares the bank intends to sell pays the cost of the creation of the ADRs. The bank handles the investor transactions. Sponsored ADRs are typically more transparent and comply more closely with the Securities and Exchange Commission (SEC) and American accounting procedures than unsponsored ADRs. Sponsored ADRs can come with shareholder voting rights and are sold in major stock exchanges like NYSE and Nasdaq.
There are three main levels of sponsored ADRs – Level I, II, and III.
Level I ADRs are the most basic ADRs. They loosely comply with SEC requirements and are the least regulated. They are only traded over the counter, which makes them more risky and speculative. This type of ADR is for companies that don’t want their ADR listed on a stock exchange. Companies mainly choose this type of ADR to test American investor interest in their securities or to establish a trading presence without raising capital.
Level II ADRs are similar to the Level I ADRs in that they only establish a presence in the stock exchange but don’t raise capital. Level II ADRs must comply with more SEC requirements than Level I ADRs.
Level III is the highest level of ADRs and the most regulated. With Level III ADRs the issuer floats a public offering on the U.S. stock exchange. Level III ADRs can be used to raise capital for the issuing company and must meet all SEC requirements.
Unsponsored ADRs: These ADRs are issued by banks, but the foreign company whose shares they represent does not participate in the trading process. Unsponsored ADRs can only be traded over the counter and not on major exchanges like the New York Stock Exchange and Nasdaq. Unsponsored ADRs don’t have voting rights.
ADR fees, dividends, and taxes
Depository bank fees: Depository banks charge a small fee for expenses related to creating and managing ADRs. This fee typically ranges between one and three cents per share and is charged either quarterly or annually.
Dividend taxes: ADRs pay dividends in the local currency. This means investors may be subject to local taxes from the company’s country, plus exchange rate fees by the bank for converting the dividends to U.S. dollars. These costs are deducted from the dividend before being given to the ADR investors. Investors may also be subject to U.S. government taxes on ADR dividends unless they claim a foreign tax credit from the Internal Revenue Service (IRS) to avoid being taxed twice on the same amount.
Capital gains taxes: ADRs are taxed as capital assets, just like U.S. stocks. This means that investors must pay capital gains taxes on any profits they make from selling ADRs.
Is ADR investment worth it?
ADRs are attractive because they behave aren’t like stocks in the U.S. stock exchange market and are easy to find and trade. Investors can also track the performance of the stock by accessing market data. It is easy to trade ADRs because they are available through American brokers trading in U.S. dollars. This also helps investors diversify their investment portfolios.
The main disadvantage of ADRs is the possibility of double taxation: foreign taxes as well as U.S. taxes. There are fewer companies with sponsored ADRs that have direct involvement in the company. Many are unsponsored and SEC non-compliant. Investors may also incur currency conversion fees.