American Depositary Receipts Are U.S.-Source Income Subject to Withholding

Editor: Mark G. Cook, CPA, MBA

Foreign Income & Taxpayers

In July, the IRS Office of Chief Counsel (OCC) released a memorandum (AM 2013-003) to address the character and source of payments by a domestic depositary institution made to, or on behalf of, a foreign corporation in consideration for a grant of the exclusive right to offer American depositary receipts (ADRs), and whether those payments are subject to withholding under Sec. 1442. In this memo, the IRS concluded that the payment is fixed or determinable, annual or periodical (FDAP) income sourced within the United States and, therefore, is subject to Sec. 1442 withholding. The withholding rate is 30% unless the foreign corporation is entitled to treaty benefits. To apply treaty benefits, the character of the payment is “other income” in the model tax treaties of the Organisation for Economic Co-operation and Development (OECD) and the United States.

American Depositary Receipt Programs

Foreign corporations (issuers) that want to make their stock more accessible to investors in the United States may enter into an agreement with a U.S. financial institution to offer the stock in an ADR program. The issuer places the stock with a U.S. depositary institution (DI). The DI offers interests in the issuer’s stock in the form of ADRs to investors in the U.S. market. ADRs can be traded on U.S. stock exchanges and over-the-counter markets. They are subject to SEC oversight. ADRs are priced in U.S. dollars. The DI makes dividend-equivalent payments in U.S. dollars to the investors based on dividends paid in foreign currency by the issuer to the DI.

An ADR program can be sponsored or unsponsored. In an unsponsored program, the issuer does not agree to use an exclusive DI. Any DI can acquire the issuer’s stock and offer ADRs to U.S. investors. In a sponsored program, the issuer and the DI enter into an agreement that the DI has the exclusive right to offer ADRs for a period. This memorandum pertains solely to payments by a U.S. DI on behalf of an issuer made in consideration for a grant of the right to be the exclusive DI, i.e., a sponsored program.

Various costs are associated with ADR programs. An issuer incurs legal fees, accounting fees, SEC registration costs, marketing expenses, expenses for participating in investor conventions, costs for acquiring and maintaining electronic communications systems, exchange and listing fees, filing fees, underwriting fees, mailing and printing costs in connection with sending out financial reports, annual reports, proxy mailings, and other administrative costs. A DI incurs expenses including listing and SEC fees, legal and accounting fees, marketing fees, and proxy and reporting fees. These fees incurred by a DI are generally passed on to the investors in the form of investor fees. As an inducement to grant an exclusive arrangement for a sponsored ADR program, a DI may offer to pay a portion of the expenses the issuer incurs to institute the program. The terms of this arrangement are set forth in a contract between the DI and the issuer.

The expenses that the DI agrees to pay for the issuer are usually subject to a cap, either a fixed dollar amount or an amount calculated by reference to the size of the ADR program. Also, the expense must be of the kind that the issuer would not have incurred but for the ADR program. The issuer generally substantiates the expenses and seeks payments from the DI within a specified time. The DI makes the payment to the issuer or to the third party on behalf of the issuer.

Character and Source for Purposes of Sec. 1442

Under Sec. 881, if a nonresident alien or foreign corporation derives investment-type income where the amount is FDAP from sources within the United States, the gross amount of that income is taxed at a flat rate of 30%. FDAP income includes dividends, interest (other than original issue discount), rents, royalties, salaries, wages, premiums, annuities, and other forms of compensation. Any person having control, receipt, custody, disposal, or payment of U.S.-source FDAP income to a foreign person must deduct and withhold U.S. tax as required by Secs. 1441(as applied to nonresident aliens) and 1442 (as applied to foreign corporations). If there is a treaty between the foreign country and the United States, a lower withholding rate may apply.

Because Sec. 1442 withholding requirements rely on the character and source of the payments made to foreign corporations, it is critical to address the character and source of the payments made by a DI to an issuer in connection with the ADR program.

In Sabatini, 98 F.2d 753 (2d Cir. 1938), the taxpayer, a nonresident alien author, entered into a number of contracts with a U.S. publisher under which he granted that company the exclusive right to publish certain books, some of which were not subject to copyright. The taxpayer was to receive under the contracts amounts determinable from the number of volumes sold. The Second Circuit held that the author’s income was from sources within the United States and said,

Though we are not fully advised as to what copyrights were actually secured, in so far as any which might have been obtained were not, the receipts by the author nevertheless fall within the statute as rentals or royalties for the use of or the privilege of using other like property. In this last named category fall also the payments received by the author from his contracts covering the publication of his uncopyrightable works. The payments were received in consideration of his granting the publisher the exclusive right to publish [in the United States]. . . . The payments were made to him for foregoing his right to authorize others for a time to publish the works here. Though others may, perhaps, lawfully have published them they could not do so under his express authority. . . . The rights he granted were an interest in property in the United States. [Emphasis added.]

The OCC found in AM 2013-003 that the payment made by the DI to the issuer as an inducement for entering a sponsored ADR program is similar to the payment in Sabatini. With this agreement, the issuer is forgoing its right to authorize other financial institutions to perform certain activities in the United States. The payment made in consideration for a grant of the exclusive right to offer ADRs represents compensation to the issuer for its transfer of an interest in property in the United States, and, therefore, it constitutes FDAP income from sources within the United States. Under Sec. 1442, these payments are subject to 30% withholding unless the applicable rate of withholding is reduced under a U.S. income tax treaty, or unless the DI receives valid documentation (i.e., Form W-8ECI, Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States) from the issuer establishing that the payments are income effectively connected with a trade or business within the United States.

Character Under U.S. Income Tax Treaties

Article 12 of the OECD Model Tax Convention on Income and on Capital, as revised by Article 12 of the 2006 U.S. Model Income Tax Convention, defines royalties as including

payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic, or scientific work or other work (including cinematograph films), any patent, trademark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.

The OCC concluded that the property right transferred by an issuer to a DI under an ADR agreement is not considered a “literary, artistic or scientific work.” Therefore, payments by a DI made to, or on behalf of, an issuer in consideration for a grant of the exclusive right to offer ADRs are not royalties within the meaning of the OECD and U.S. model treaties.

The OCC determined that the ADR program payments also do not fit within the scope of “business profits” articles of the OECD and U.S. model treaties. Under Article 3 of the model treaties, the term “business” includes the performance of professional services and of other activities of an independent character. Profits are broadly defined as all income from carrying on an enterprise. The OCC found that neither issuing stock nor contracting with DIs to conduct the ADR program is by itself a business. Therefore, the payments are not business profits but are “other income” within the meaning of the OECD and U.S. model treaties.

However, the OCC noted that under Article 21 of the model treaties, only the country of residence may tax income that falls within the scope of other income. Thus, if the issuer is a resident under a specific tax treaty and satisfies the “Limitation on Benefits” article of the U.S. Model Treaty (Article 22), the “Other Income” article would eliminate the U.S. withholding tax on the ADR program payments. The OCC further stated that under typical facts, issuers would satisfy the U.S. Model Treaty limitation on benefits because publicly traded companies are permitted to claim treaty benefits in the country where they are listed, but that the “Other Income” and “Limitation on Benefits” articles of the applicable treaty should be consulted to determine if this is true in a particular case.

Conclusion

When a U.S. financial institution makes payments to a foreign corporation issuer under the agreement of a sponsored ADR program, the payments are considered the foreign corporation’s FDAP income sourced within the United States. Therefore, the payments are subject to Sec. 1442 withholding at 30% unless a special treaty rate applies or the foreign corporation provides valid documents to establish that this income is effectively connected with a U.S. trade or business. For the purpose of U.S. income tax treaties, the ADR program payments are characterized as other income, not royalties or business profits.

EditorNotes

Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600, ext. 2143, or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.