American depositary receipts (ADRs)

Learn what American depositary receipts (ADRs) are, how they work, their types, pricing, fees, and tax implications, plus the pros, cons, and real-world examples for investors.

If you’ve seen the names of foreign companies on U.S. exchanges, you’ve likely come across what’s known as an American Depositary Receipt (ADR). In this blog, we explain what ADRs are, how they work, different types of ADRs, their pricing structure, and the advantages and disadvantages of trading American Depositary Receipts. 

What are American Depositary Receipts (ADRs)? 

ADRs provide an easy way for U.S. investors to gain exposure to foreign company stock not listed on US exchanges. They represent shares in a stock, allowing them to be traded on U.S. markets like the Nasdaq or New York Stock Exchange (NYSE) while the actual shares stay on their home exchange.  

ADRs simplify foreign investing for U.S. investors wanting exposure to international markets and global names like Shell, Unilever, Alibaba, or Sony. For companies, ADRs are a way to access U.S. investors without going through the expensive and time-consuming process of listing their shares directly on a second exchange.

How American Depositary Receipts work

ADRs are priced and traded in U.S. dollars (USD), making them just as easy to buy and sell as any other American stock. Here’s how the process works behind the scenes:

1. A bank purchases shares: First, a U.S. depositary bank (a specialist bank like JP Morgan or Citibank) identifies a foreign company that U.S. investors might want to buy. The bank purchases a large block of that company’s shares on its home exchange.
2. The shares are held in custody: The U.S. bank finds a custodian bank in the company’s home country to hold the shares on their behalf.
3. The ADR is issued: The U.S. depositary bank then issues a receipt to represent those shares. This is the ADR. These receipts are then listed on a U.S. exchange or over-the-counter (OTC) for investors to trade.
4. Trading begins: Once an ADR is listed, you can buy and sell it through your regular brokerage account, just like a regular U.S.-based company. The trade settles in U.S. dollars and the timing of your orders follows standard U.S. trading hours.  

Note that one ADR doesn’t always represent exactly one share of the foreign company. They can sometimes represent a fraction of a share, or even multiple shares. This pricing mechanism allows banks to keep the ADR price at a level familiar to U.S. investors.

Types of ADRs

There are two main ways that an ADR can be created: with the company’s help or without it. These are known as sponsored and unsponsored ADRs.

Sponsored American Depositary Receipts

Sponsored ADRs are created when the foreign issuer works directly with the U.S. bank. The company pays the costs of setting up the ADR and remains in control throughout the process. Because the company is involved, these ADRs can be listed on major U.S. exchanges and often come with voting rights for the investor.  

Unsponsored American Depositary Receipts

Unsponsored ADRs are set up by the U.S. bank without the foreign company’s direct permission or involvement. This usually happens when there is high demand from U.S. investors for a specific foreign stock.

Because the company isn’t involved in an unsponsored ADR, you could have several different banks issuing their own ADRs for the same company. These ADRs would only trade over-the-counter (OTC) and not on major exchanges. Unlike sponsored ADRs, investors don’t usually get voting rights with unsponsored ADRs. 

The three levels of ADRs

There are three different levels of sponsored ADRs, each of which represents how much information the company shares with the U.S. government and where the shares are allowed to trade.

Level I ADRs

Level 1 ADRs are the most basic type, often used by smaller foreign companies that want to test if U.S. investors are interested in their stock. 

These ADRs only trade on the OTC market and aren’t typically listed on major exchanges. Companies have minimal reporting requirements and don’t have to file regular reports with the Securities and Exchange Commission (SEC). However, they must publish an English version of their home-country annual report on their website.

Companies issuing Level 1 ADRs cannot raise capital from investors.

Level II ADRs

Level II ADRs can also be used to test U.S. interest, however they offer higher visibility and more trading volume.

These ADRs can be listed on major exchanges, like the Nasdaq or NYSE. Companies must register with the SEC and provide annual reports that meet U.S. accounting standards. They must also follow the specific rules of the exchange they’re listed on, making them less risky than Level 1 ADRs.

Like Level 1 ADRs, Level 2 ADRs only represent shares that already exist and can’t be used to raise capital. 

Level III ADRs

Level III ADRs are the most prestigious. This is the type of ADR issued by the world’s largest international brands. 

Like Level II ADRs, Level III ADRs are listed on major U.S. stock exchanges. However, they have the strictest reporting rules and must follow reporting standards almost identical to those of U.S.-based companies.

This is the only level that allows foreign companies to raise capital by issuing new shares to U.S. investors. 

Pricing, fees, and taxes on ADRs

Pricing of ADR shares

ADR prices usually mirror the price of the stock on its home exchange, adjusted for the exchange rate. However, one ADR doesn’t always equal one share of the foreign company. This is known as the ADR ratio.

For example, NIO has an ADR ratio of 1:1, meaning one ADR equals one NIO share. Alibaba, however, has an 8:1 ratio, meaning one ADR represents eight individual shares. In some cases, one ADR will represent a fraction of a high-priced foreign share (e.g. 1/10).

Banks set the ADR ratio to make the share price make sense to U.S. investors. In other words, it doesn’t appear too expensive (which can scare off buyers) or too cheap (which can look risky).

Fees associated with ADR investments

Depositary banks often charge a service fee, known as the custody fee, to cover the cost of issuing an ADR. This fee is usually somewhere between $0.01 and $0.05 per share annually.

If the company pays a dividend, the bank will typically just subtract the fee before the money hits your account. If the company doesn’t pay a dividend, the fee might be deducted from your brokerage account balance as a pass-through fee.

You’ll find all information about fees listed in the ADR prospectus, which is on the SEC’s website. 

Tax implications for ADR holders

There is a bit of complexity involved with investing internationally, but luckily, this is usually handled automatically with ADRs.

When a foreign company pays a dividend, their home government might take a cut (withholding tax) before the money is sent to the U.S. To prevent you from being taxed twice on the same income, the IRS often allows you to claim a Foreign Tax Credit on your U.S. tax return for the amount already withheld overseas.

Note, while ADRs save you from paying foreign transaction taxes, you are still responsible for standard U.S. capital gains taxes when you sell your ADR for a profit.

This material is for informational purposes only and does not constitute tax advice. You should seek advice from an independent, qualified tax professional before making any investment decisions.

Related instruments and key ADR terminology

American Depositary Receipts vs American Depositary Shares (ADSs)

American Depositary Receipts and American Depositary Shares are often used interchangeably, but there is a difference between them:

• The ADR is the certificate that represents shares
• The ADS is the actual underlying stock available for trading.

In other words, the ADR represents the ADS. 

American Depositary Receipts vs Global Depositary Receipts (GDRs)

An ADR is specifically designed for the U.S. market and is traded in U.S. dollars. A Global Depositary Receipt (GDR) is similar, but designed to be traded in multiple markets at the same time (e.g. both in Europe and the U.S.).

GDRs are often used by large companies wanting to raise money from investors all over the world simultaneously. They are often traded on the London Stock Exchange (LSE) or Luxembourg Stock Exchange (LuxSE).

Advantages and disadvantages of investing in ADRs

Advantages of ADR investing

Some of the benefits of investing in ADRs include:

• Easy access: ADRs trade just like U.S. stocks. You can buy them through a regular brokerage account without having to open a foreign account or navigate international exchanges.
• Priced in U.S. dollars: ADRs are denominated in USD, allowing you to clearly understand your gains and losses without having to manually calculate exchange rates each time you check your portfolio.
• Global diversification: ADRs allow you to spread your investments across different countries and industries. This can help reduce overall risk by ensuring you’re not only exposed to the U.S. economy.
• Familiar reporting: Companies with Level II and Level III ADRs must provide financial reports in English that follow standard U.S. accounting rules (e.g. Generally Accepted Accounting Principles), making it easier to understand and research.

Disadvantages and risks of ADR investing

Some of the drawbacks of investing in ADRs include:

• Foreign exchange risk: Even though you trade ADRs in dollars, their underlying value is still tied to a foreign currency. If that currency weakens against the U.S. dollar, the value of your ADR could drop, even if the underlying company’s stock price stays the same.
• Double taxation: You might be taxed on dividends by both the foreign government and the U.S. That said, you may be able to claim a tax credit for this, but it still adds a bit of extra complexity.
• Limited selection: Not every international company has an ADR, giving you limited options for trading.
• Political & economic risk: Like any foreign investment, ADRs are subject to the stability of the company’s home country. This means that political unrest, high inflation, or any new regulations in that country could have a negative impact on your investment.

Evolution of ADRs over time

ADRs were first introduced in the 1920s. At that time, U.S. investors could only purchase shares of non-U.S. companies on international exchanges – something that was almost impossible for the average American at the time. 

The concept of ADRs was developed by Guaranty Trust Co., a predecessor of JP Morgan. The first ADR was launched in 1927 for the British retailer, Selfridges, which was listed on the New York Curb Exchange (now the NYSE). In 1931, the first sponsored ADR was introduced for the British music company, Electrical & Musical Industries (EMI),  a company that would later sign the Beatles. 

Examples of ADRs in practice

One example of an ADR in practice is the story of Volkswagen (VW). Between 1988 and 2018, Volkswagen had a sponsored ADR program under the ticker VLKAY. But in August 2018, the German company decided to terminate this program to reduce its U.S. regulatory requirements.

Immediately after the sponsored program ended, JP Morgan established an unsponsored ADR under the ticker VWAGY so that U.S. investors could continue trading the stock. This gave investors who held the old VLKAY three options:

1. Cash out and sell their holdings for the current market value
2. Trade their ADRs for actual Volkswagen stock that trades on the German exchange (though this would require a broker capable of holding international shares)
3. Move their investment into the new unsponsored VWAGY ADR issued by JP Morgan.

This isn’t an example of how most ADRs go, but it does highlight how a company can choose to end its ADR program at any time. It also illuminates the difference between sponsored and unsponsored ADRs.

Example of dividend payments and fees on an ADR

To understand how an ADR might work in your portfolio, let’s use an example with a hypothetical UK-based company called BritTech, which trades as an ADR in the U.S.

Here’s how it would work if BritTech paid a dividend:

1. BritTech would distribute a dividend of £1.00 per share
2. The U.S. depositary bank would receive the pounds and convert them into USD at the current exchange rate
3. The bank automatically withholds any foreign taxes required by the U.S. government
4. If the exchange rate is $1.30 per £1.00, you’ll receive $1.30 per ADR into your brokerage account (minus the bank’s currency conversion costs and service fees).

When it comes to service fees, the depositary bank would usually charge between $0.01 and $0.05 per share for managing the ADR. This fee is subtracted from your dividend before you receive it.

If the stock doesn’t pay dividends, then the bank may charge the fee to your broker once a year, who would then deduct it from your cash balance. This is often labeled as an ‘ADR Pass-Through Fee’ on your statement.