American Depositary Receipts (ADRs): Meaning, Origin & How They Work

American Depositary Receipts (ADRs) Meaning in Share Market

American Depositary Receipts (ADRs) are a type of security that allows investors to buy and sell shares of foreign companies on US stock exchanges. ADRs provide US investors with a convenient way to invest in foreign companies, without having to deal with the complexities of trading on foreign exchanges or converting currencies. This is what ADR means in the share market. 

How do American Depositary Receipts (ADRs) work?

Understanding what is ADR in stocks and how it works is essential for investors looking to diversify their portfolio. American Depositary Receipts (ADRs) work by allowing US investors to buy and sell shares of foreign companies on US stock exchanges. ADRs are issued by US depository banks that hold the underlying foreign company shares in custody.

The depository bank issues ADRs representing a certain number of foreign company shares, and these ADRs can be bought and sold just like regular stocks on US exchanges. The value of the ADRs is based on the value of the underlying shares in the foreign market, adjusted for currency exchange rates and other fees.

ADRs simplify the process of investing in foreign companies for US investors, as they can be traded in US dollars and do not require direct dealings with foreign markets or currencies.
 

Taxing and reporting

From an Indian tax perspective, investing in American Depositary Receipts (ADRs) is considered a foreign investment and is subject to foreign exchange regulations and taxation. When an Indian resident invests in ADRs, they are required to comply with the Reserve Bank of India's (RBI) regulations governing outward remittances, which means that they must have a valid bank account and tax registration number. 

Dividends received on ADRs are subject to tax in India at the applicable rates, and any capital gains resulting from the sale of ADRs are also subject to tax in India, depending on the holding period and other factors. Investors may also be eligible for foreign tax credits to offset any taxes paid on the ADRs in the foreign country. 

Indian investors holding ADRs are required to report their foreign investments and any income earned on those investments on their tax returns, and failure to do so can result in penalties and fines.

Different Types of ADR programs

There are two primary categories of American depositary receipts:

Sponsored ADRs 

In sponsored ADRs, a bank acts on behalf of the foreign company to issue the ADR and handles transactions with investors, while the foreign company retains control over the ADR and usually pays the costs of issuance. 

Unsponsored ADRs

Unsponsored ADRs are issued by a bank without the direct involvement or permission of the foreign company. Multiple unsponsored ADRs for the same foreign company may be issued by different U.S. banks, and these offerings may have varying dividends. 

ADR Levels 

ADRs are categorised into three levels, based on the level of compliance with SEC regulations each offering a different level of flexibility and liquidity to investors. These levels are:

Level 1 ADRs:

●    These are the simplest and least expensive types of ADR programs.
●    They allow foreign companies to list their shares on US stock exchanges without having to comply with the Securities and Exchange Commission (SEC) registration requirements.
●    Level 1 ADRs are traded on US stock exchanges like regular stocks and are denominated in US dollars.
●    However, they are not backed by the underlying foreign shares, and investors do not have voting rights or the ability to convert the ADRs back into foreign shares.

Level 2 ADRs:

●    These ADRs require the foreign company to comply with the SEC's registration requirements, making them more expensive and time-consuming to establish than Level 1 ADRs.
●    Level 2 ADRs are traded on US exchanges and are backed by the underlying foreign shares.
●    They offer investors voting rights and the ability to convert the ADRs back into foreign shares.
●    Level 2 ADRs can be used to raise capital through secondary offerings, allowing the foreign company to issue new ADRs to US investors.

Level 3 ADRs:

●    These are the most expensive and complex types of ADR programs.
●    Level 3 ADRs allow foreign companies to issue new shares and raise capital directly from US investors, without having to comply with the SEC registration requirements.
●    Level 3 ADRs can only be issued by companies that have been publicly traded for at least one year and meet certain financial and governance requirements.
●    Level 3 ADRs provide the most flexibility and liquidity to investors, as they can be traded freely on US exchanges and can be converted back into foreign shares at any time.

American Depositary Receipt Pricing and Costs

The pricing and costs of American Depositary Receipts (ADRs) can vary depending on a variety of factors. Here are some key considerations:

1.    Conversion ratio: The conversion ratio of an ADR refers to the number of foreign shares that underlie each ADR. The ratio affects the price of an ADR and can vary depending on the level of the ADR.
2.    Depositary bank fees: A depositary bank charges fees for its services in issuing and maintaining the ADR program. These fees include initial setup fees, custody fees, transaction fees, and other expenses, which can vary depending on the level of the ADR.
3.    Foreign exchange rates: ADRs are priced in U.S. dollars, but the underlying foreign shares are denominated in the local currency. Changes in foreign exchange rates can impact the value of the ADR.
4.    Trading fees: Investors may have to pay fees for buying and selling ADRs, which can vary depending on the broker and the trading platform.

Investors should carefully consider these factors and do their due diligence before investing in ADRs.

ADR Fees

American Depositary Receipts (ADRs) can involve several fees for both the issuer and the investor. Here are some of the fees that may apply:

1.    Depositary bank fees:
2.    Brokerage fees: 
3.    Currency conversion fees: 
4.    Taxes: 
5.    Redemption fees: 

The fees can impact the overall return on investment and should be weighed against the potential benefits of investing in ADRs.

ADRs and Taxes

American Depositary Receipts (ADRs) are subject to taxes in both the United States and the home country of the foreign company. Here are some key tax considerations related to ADRs:

1.    Dividend withholding tax: 
2.    U.S. taxes
3.    Foreign tax credit: 
4.    Tax treaties

The tax rules and rates can vary depending on the specific ADR program and the home country of the foreign company.

Advantages and Disadvantages of American Depositary Receipts

Advantages of American Depositary Receipts (ADRs):

1.    Access to foreign markets: ADRs allow U.S. investors to invest in foreign companies without having to navigate foreign stock exchanges or deal with currency exchange rates.
2.    Convenience: ADRs trade on U.S. stock exchanges, making it easy for U.S. investors to buy and sell them using their existing brokerage accounts.
3.    Diversification: ADRs offer U.S. investors the opportunity to diversify their portfolios by investing in foreign companies across a range of industries.
4.    Liquidity: ADRs are typically more liquid than their foreign counterparts, as they trade on major U.S. stock exchanges.
5.    Transparency: ADRs are subject to the same reporting and disclosure requirements as U.S. companies, which can provide investors with greater transparency and information about the foreign company.
6.    Potential for higher returns: Investing in foreign companies through ADRs can provide U.S. investors with the potential for higher returns compared to investing only in domestic companies.
7.    Hedging opportunities: ADRs can provide investors with opportunities to hedge against currency fluctuations through various financial instruments.

Disadvantages of American Depositary Receipts (ADRs):

1.    Currency risk: ADRs are subject to currency exchange rate fluctuations, which can impact the value of the investment.
2.    Market risk: Investing in foreign companies through ADRs exposes investors to the risks associated with those companies and their local markets.
3.    Fees: ADRs can come with higher fees compared to investing in domestic companies, including depositary fees, custody fees, and foreign currency conversion fees.
4.    Limited availability: ADRs may not be available for all foreign companies, particularly smaller ones.
5.    Lower dividend payouts: ADRs may have lower dividend payouts compared to their foreign counterparts, as they may be subject to dividend withholding taxes in their home countries.
6.    Lack of voting rights: ADRs may not offer the same voting rights as their foreign counterparts, which can limit investor influence over the foreign company.
7.    Regulatory differences: The foreign company may be subject to different regulatory frameworks and accounting standards compared to U.S. companies, which can make it more difficult for U.S. investors to evaluate the investment.

ADR risk factors and expenses

ADR risk factors and expenses include:

1.    Currency Risk: ADR investors may face currency risk due to fluctuations in exchange rates between the US dollar and the foreign currency in which the underlying shares of the foreign company are denominated.
2.    Political Risk: Political instability or changes in the foreign country where the company operates may adversely affect the value of the ADR.
3.    Liquidity Risk: Some ADRs may have low trading volumes, making it difficult for investors to buy or sell them quickly, and this may cause price volatility.
4.    Custodian Fees: ADRs are issued and maintained by custodian banks, which charge a fee for their services, including depositing dividends, collecting voting rights, and other administrative tasks.
5.    Conversion Fees: Investors may have to pay conversion fees to convert their US dollars into the foreign currency needed to buy the underlying shares of the foreign company.
6.    Taxes: Investors may have to pay taxes in both the US and the foreign country where the company operates, which can add to the overall cost of investing in ADRs.
7.    Regulatory Risks: Regulatory changes in either the US or a foreign country where the company operates can impact ADRs.

Conclusion

American Depositary Receipts (ADRs) provide exposure to foreign markets, diversify investment portfolios, and offer investors access to a wider range of investment opportunities. However, ADRs also come with certain risks that investors also need to be aware of. Investors need to carefully consider the risks and expenses associated with investing in ADRs and consult with a financial professional before making any investment decisions.

The Origin and Evolution of American Depositary Receipts (ADRs)

Before ADRs existed, U.S. investors had limited access to foreign stocks, often needing to trade directly on overseas exchanges—a costly and complicated process. To simplify this, Guaranty Trust, the forerunner of J.P. Morgan, introduced the first ADR in 1927 for Selfridges, a British retailer. This move allowed the shares to be traded in the U.S., bridging global markets. A few years later, in 1931, the first sponsored ADR was launched for Electrical & Musical Industries, marking another milestone. Over the decades, institutions like J.P. Morgan and BNY Mellon have played a central role in the ADR ecosystem.
 

Practical Example of an American Depositary Receipt (ADR)

Volkswagen AG previously traded in the U.S. via a sponsored ADR under the ticker VLKAY. After the programme ended in 2018, J.P. Morgan launched an unsponsored version—VWAGY. Investors could either convert their holdings, redeem them, or switch to the new ADR.
 

Why Do Foreign Companies List ADRs?

Foreign companies list ADRs to tap into the U.S. investment market without undergoing the full process of a domestic listing. It gives them access to a larger pool of capital, broader analyst coverage, and increased brand visibility among American investors. At the same time, ADRs help bypass the hurdles of foreign currency conversions and differing trading practices. For companies, it’s a practical way to grow their global investor base while maintaining compliance with fewer regulatory demands than a direct U.S. listing.
 

ADR vs GDR