American depository receipts allow investors to invest in foreign companies by purchasing ADR shares on U.S. stock exchanges. Each ADR share is backed by a share or shares of the foreign company held in trust by a U.S. bank. If a foreign company pays a dividend, the ADR-issuing bank collects the money and passes it along to ADR investors, converting currency if necessary.
The tax rate on dividends from qualified corporations is lower than the regular income tax rate an investor pays, with a maximum tax rate on qualified dividends of 15 percent. According to tax code rules, qualified dividends can be paid by qualified foreign corporations. If the shares of a foreign company trade in the U.S. as an ADR listed on one of the U.S. stock exchanges, the corporation pays qualified dividends at a lower tax rate.
Foreign Tax Withholding
Tax laws in many foreign countries require taxes to be withheld from dividends before they are paid out to foreign investors. An investor buying ADR shares is a foreign investor to the home country of the company behind the ADR. The result is that foreign taxes are withheld from ADR dividends before they are paid to shareholders. Some ADR tax rates for countries include 25 percent for Australia, 15 percent for Canada, 26.4 percent for Germany and 35 percent for Switzerland.
Claiming Foreign Taxes Paid
The bank that issued the ADRs held by an investor will issue a 1099 DIV at the end of the year listing the dividends paid, whether the dividends were qualified and the amount of foreign tax withheld. The investor can claim the foreign taxes withheld as a direct tax credit, reducing her income tax bill dollar-for-for dollar by filing an IRS Form 1116 -- Foreign Tax Credit -- with her annual income tax return. Instead of filling the Form 1116, the foreign taxes withheld can also be claimed as an itemized deduction.
ADRs in IRAs
If ADR shares are owned in an individual retirement account and foreign taxes are withheld from the dividends, those foreign taxes paid cannot be claimed on an investor's income tax return. If the ADRs are from a German or Canadian company, tax treaties with these countries eliminate foreign tax withholding from dividends earned from ADR units owned in IRA accounts.
- Dividends Explained: American Depositary Receipt (ADR)
- topforeignstocks.com: Withholding Tax Rates by Country for Foreign Stock Dividends
- Internal Revenue Service. "Foreign Tax Credit." Accessed Jan. 23, 2020.
- Internal Revenue Service. "Publication 514: Foreign Tax Credit for Individuals," Page 3. Accessed Jan. 24, 2020.
- Internal Revenue Service. "Foreign Tax Credit - Choosing To Take Credit or Deduction." Accessed Feb. 9, 2020.
- Internal Revenue Service. "Publication 514: Foreign Tax Credit for Individuals," Page 2. Accessed Jan. 24, 2020.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.