In a legal advice memorandum (AM 2013-003) released July 12, 2013, the IRS Associate Chief Counsel (International) analyzes the character, source and treatment of payments by a domestic depositary institution in consideration for a foreign corporation’s grant of the exclusive right to offer American Depositary Receipts (ADR). The memorandum concludes that the payments represent compensation for the transfer of a property interest in the United States, constitute U.S. source income and are subject to 30-percent withholding tax under Code Section 1442, unless the rate is reduced by a treaty. Moreover, the payments are likely “other income” under U.S. and OECD model treaties—not “royalties” or “business profits”—which means U.S. (source state) taxation could be eliminated entirely.

Background

In an ADR program, a foreign issuer places its stock with a U.S. financial institution (a “Depositary Institution” or DI) to make the stock more accessible to investors in the United States. The DI, which maintains and controls the stock, offers interests in the stock in the form of ADRs and makes dividend equivalent payments in U.S. dollars based on dividends paid by the issuer to the DI in foreign currency. Investors can trade ADRs on U.S. exchanges and OTC markets. ADR programs are subject to oversight by the SEC. In sponsored ADR programs, the subject of the AM, the foreign issuer enters an agreement with a specific bank to be its exclusive DI for a specified period of time. Unsponsored programs, in contrast, allow any DI to acquire the issuer’s stock and offer ADRs to investors. The DI charges certain fees for administering the ADR programs to investors (and sometimes the issuer).

Issuers incur significant expenses to establish ADR programs, including accounting and legal fees, SEC registration costs, marketing expenses, exchange and listing fees, and other costs. To induce an issuer to enter an exclusive, sponsored ADR program, DIs commonly offer to pay a portion of these expenses. A DI may pay an issuer directly or to third-party vendors on behalf of the issuer.

AM 2013-003 Analysis

The character of particular ADR program-related payments depends on the facts and circumstances. In the case of inducement payments for sponsored ADR programs, the IRS concludes that the payments represent consideration for the transfer from the issuer to the DI of exclusive rights to establish a sponsored program for the issuer’s stock. Citing Sabatini v. Commissioner, 98 F.2d 753 (2d Cir. 1938), a case where a nonresident alien author granted exclusive U.S. publishing rights, the memorandum determines that the exclusive ADR program rights constitute property interests located in the United States. Furthermore, payments for the transfer of those rights are U.S. source fixed or determinable annual or periodic (FDAP) income and subject to 30-percent withholding under Section 1442, unless the rate is reduced by a treaty (or the income is effectively connected with a U.S. business).

The IRS next considers the application of treaties to the payments. According to the memorandum, the payments are not “royalties”: although the exclusive ADR program rights are property interests, the U.S. and OECD model treaties define royalties more narrowly than the Code. Nor do the payments constitute “business profits” under the treaties, because the payments do not relate to the issuer’s business. (The IRS clarifies that issuing stock and contracting with DIs to conduct ADR programs do not constitute businesses in themselves.) Because the payments are not described in specific treaty provisions, the payments fall under the models’ “other income” articles, which generally permit taxation by the country of residence only.

Conclusion

For foreign issuers establishing sponsored ADR programs that are eligible for U.S. tax treaty benefits—and the domestic DIs running the programs—AM 2013-003 seems like good news. The memorandum clearly contemplates the elimination of U.S. tax on payments foreign issuers receive from DIs for exclusive ADR program rights under a treaty. Of course, the specific provisions of the operative treaty must be considered to determine whether and to what extent U.S. tax applies.