Do ADRs Qualify for the Special Tax Rate on Dividends?

ADRs are American Depository Receipts, which are certificates that evidence ownership of ADSs – American Depository Shares. The term ADRs and ADSs are often used interchangeably. The ADSs are shares of a foreign company that are held on deposit by a custodian bank in the U.S.

ADRs are U.S. dollar-denominated shares of equity ownership in non-U.S. companies. From the foreign companies’ standpoint, ADRs provide them with the opportunity to raise capital directly on U.S. securities markets. And for U.S. investors, ADRs provide a convenient way to invest in foreign stocks through their U.S. broker, without having to go through a foreign stock exchange in the company’s home country. There may be fewer obstacles and lower transaction costs than there would be if the investor were to purchase shares in the company directly on the foreign stock exchange.

In order for foreign companies to place their ADRs on U.S. securities markets, they also have to comply with Securities and Exchange regulations and reporting requirements, so there is more assurance for the U.S. investor that the shares they are purchasing meet the standards applicable for U.S. companies, and that there will be the same level of transparency in reporting.

ADRs are traded in the same way as U.S. stocks, and are listed on the New York Stock Exchange, the American Stock Exchange, or are traded on the NASDAQ or on the over-the-counter market. ADRs are traded according to U.S. market practices, are quoted in U.S. dollars, and dividends are paid in U.S. dollars.

Dividends Taxed at Capital Gain Rates

The Jobs and Growth Tax Relief Reconciliation Act of 2003 included provisions that reduced the tax rate on certain dividends to the lower rate applicable on capital gains. This rate is generally 15%, and 5% for taxpayers in the lower tax brackets. The provision applies to dividends from domestic U.S. corporations and qualified foreign corporations (QFCs). Distributions from a foreign corporation only qualify for these preferential tax rates if they are dividends according to U.S. tax rules, and the corporation qualifies as a QFC.

Qualified Foreign Corporation

One of the qualifying tests for a QFC is that it pays a dividend on stock that is “readily tradable on an established securities market in the United States”. Since ADRs meet this criteria, they would qualify as securities of a qualified foreign corporation.

Qualifying Dividends

In order for a distribution from a foreign corporation to be considered a dividend for U.S. income tax purposes, the underlying security must be an equity security and not debt, and the distribution must be made from earnings and profits. The security is considered equity if it is a common or ordinary share of stock, or if there is a public Securities and Exchange Commission (SEC) filing, stating that the security will be treated as equity for U.S. income tax purposes. An ADR would meet this test.

Qualifying dividends on an ADR would be reported in box 1b of the Form 1099-DIV that the investment account manager or broker sends you. These qualifying dividends are the ordinary dividends that are subject to the maximum tax rates that apply on net capital gains. If the regular tax rate that would otherwise apply to your ordinary income is 25% or higher, the maximum tax rate on qualifying dividends is 15%. And if your regular tax rate is lower than 25%, the qualified dividends would be subject to tax at 5%.

Holding Period

In order for the dividends to qualify for the special capital gains tax rate, there is a holding period test. For common stock, you must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date after the declaration of a dividend on which the buyer will not receive the next dividend payment. In other words, the ex-dividend date is the date on which the stock starts trading without the dividend.

For dividends on preferred stock that correspond to a period or periods that total more than 366 days, you must have held the stock for more than 90 days during the 181-day period that begins 90 days before the ex-dividend date. If the dividends correspond to a period of 366 days or less, the holding period for common stock applies.

In determining whether you meet the holding period test, you include the date you sold or disposed of the stock, or ADR, in your holding period, but not the date you acquired it. And the holding period is based on calendar days, so you need to take into consideration the number of days in each month involved in your holding period.

Your holding period may be affected if you enter into a transaction that diminishes your risk of loss. You cannot include any days on which you reduced your risk of loss on the investment, for example through short sales. You could not count any days on which:
�· You had an option to sell, were contractually obligated to sell, or you had made (but not closed) a short sale of substantially identical stock or securities.
�· You granted an option to buy substantially identical stock or securities.
�· You hedge your loss by holding one or more positions in substantially similar or related property.

If you meet the holding period test, the dividends are qualifying dividends and are taxed at the capital gain rates (15% or 5%, depending on your tax bracket). If you do not meet the holding period test, the dividends would not qualify for these preferential rates and would be subject to tax as ordinary income at your regular tax rate.

Your Form 1099-DIV may show ordinary dividends in box 1a and qualified dividends in box 1b. But if you do not meet the holding period requirement, even though the 1099-DIV shows qualified dividends, you will not be able to take advantage of the lower capital gain rates, and would have to report all the dividends as ordinary income. This may be a factor to take into consideration when deciding when to sell the ADR. Depending on how the market price of the ADR is moving, and how you expect it to move, you may want to extend your selling date in order to meet the holding period requirement and qualify for the lower tax rate. One simple way to look at the holding period is that if you received the dividend and owned the ADR for more than 60 days, you will have met the holding period requirement.