Although ADR certificates are issued by US banks, it still represents shares in a foreign company. In essence, you are investing in a non-US asset, and the taxation involved can become a bit complicated.
Since the actual shares of the company that you’re buying through an ADR are being held by a bank native to the stock, you’re subject to that country’s tax laws as well as your own.
Taxed Dividends on ADRs
Just like US stocks, dividends paid on ADR shares are generally taxable. There are a number of other variables that depend on the situation, including the possibility that the company’s local government will withhold taxes on your dividends – sometimes to the extent that this revenue is negated completely.
This is why it’s important to thoroughly examine the tax scenario on a particular ADR before you invest. When in doubt, consult a tax advisor.
There are some circumstances where local taxes withheld can be applied as a credit to your US taxes, and sometimes you can take advantage of a tax reclaim opportunity. Again, this is why the counsel of a tax professional is often worth its weight in gold.
Avoiding Double Taxation
You might be catching wind of a little Catch-22 in this whole process: namely, double taxation. This isn’t something that the IRS wants to subject you to, believe it or not, and therefore there are some safeguards in place.
The IRS has a system in place through which investors an take a tax credit or a tax deduction to avoid being taxed twice. There are many considerations involved in this process, and I’m not a tax professional, so you’ll probably want to enlist the aid of a tax advisor when making the call.
I can tell you this much: tax deductions are easier to figure out, but they’re usually not the best option. A tax credit will have a direct dollar-value impact on your tax liabilities, whereas a deduction is subject to a percentage-based calculus that will often leave you holding the short end of the stick.
Filing a Form 1116 for Foreign Tax Credits:
Think of it as a difference between elimination and mitigation. The credit will eliminate the burden of foreign taxation, while a deduction will usually only mitigate the same burden. Which would you choose? Most likely, you’ll be reaching for that Form 1116, despite the fact that it can get complicated.
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