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When U.S. depository institutions pay the expenses of issuers of ADR programs, tax may be withheld under certain circumstances.
Robert Willens, CFO.com | US
January 10, 2011
Programs that make foreign issuers' stock available in domestic markets are known as American Depositary Receipt (ADR) programs. In an ADR program, an issuer's stock is placed with and maintained and controlled by a depository institution (DI). The DI, a domestic financial institution, then offers interests in the issuer's stock, in the form of ADRs, to investors in domestic markets. U.S. investors can trade ADRs on U.S. exchanges and OTC markets, as they do shares of domestic companies.
An ADR program may be either unsponsored or sponsored. An unsponsored ADR is issued without the involvement of the foreign issuer whose stock underlies the ADR. In a sponsored program, the issuer registers with the Securities and Exchange Commission and chooses an exclusive DI. As an inducement to grant an exclusive arrangement for a sponsored ADR program, DIs commonly offer to pay part of the expenses the issuer will incur in setting up the program.
The expenses typically paid by the DI include legal, accounting fees, SEC registration costs, marketing expenses, expenses for participating in investor conventions, and exchange and listing fees. They also include filing and underwriting fees, mailing and printing costs, and other administrative costs. The Internal Revenue Service has ruled that the issuer realizes gross income in an amount equal to the expenses paid by the DI on the issuer's behalf (see AM 2010-006, December 8, 2010).
It is, the IRS noted, "well-established" that the payment of the expenses of a taxpayer by someone else is includible in the taxpayer's gross income (see Old Colony Trust v. Commissioner, 279 US 716 (1929)). The payments are includible regardless of whether they are made directly to the taxpayer or to a third party on his or her behalf.
A taxpayer does not have gross income when it pays the expenses of another person and receives a reimbursement of its payments. When, however, a person pays someone else's expenses mainly to advance the business interests of the person making the payments, the payments are not includible in the gross income of the recipient, notwithstanding any incidental or indirect economic benefit to the recipient. (See United States v. Gotcher, 401 F.2d 118 (5th Cir. 1968); Rev. Rul. 63-77, 1963-1 C.B. 177; and Rev. Rul. 80-348, 1980-2 C.B. 31. In all three instances, the expenditures were primarily for the benefit of the payer.)
Here, though, the expenses paid by the DI are unequivocally those of the issuer in that (1) the payments are for expenses any issuer would expect to incur to sell its stock in the United States; (2) the DI does not have a preexisting obligation to incur these expenses, the source of its obligation being solely by virtue of its agreement with the issuer; (3) the issuer has discretion over which vendor to use in instituting its DI program when it incurs the expenses; and (4) the DI does not pay all the expenses necessary to set up the ADR program, but only up to an agreed amount.
Moreover, the DI has not paid any direct consideration for the exclusive right to serve as such, thus suggesting that its payments of the expenses are intended to compensate the issuer for its agreement to deal exclusively with the DI. Finally, the DI's payments are "primarily and directly" for the issuer's benefit in instituting the ADR program; they are not primarily for the DI's benefit.
As a result of all those reasons, the IRS concluded, the payments by the DI of the issuer's expenses are gross income to the issuer.
For the same reasons that a taxpayer does not have gross income when it pays the expenses of another person and receives a reimbursement of its payments, the taxpayer should not be allowed a deduction for the payment of another's expenses if the other person has agreed to reimburse the taxpayer.
Thus, some may argue that, since the issuer would not be entitled to a deduction for its expenses to the extent it will be reimbursed by the DI for its expenses, it should not have gross income when the DI pays the issuer for the expenses. This argument, however, is specious, according to the IRS. That is because the expenses are the issuer's expenses, not the DI's. Therefore, the issuer should not be denied a deduction for the expenses merely because the DI has agreed to pay a portion of them.
Section 1441 of the Internal Revenue Code requires any person making a payment of U.S. source fixed or determinable annual or periodical income (FDAP) to a nonresident alien to withhold a tax from the payment unless the income is "effectively connected" with a U.S. trade or business. Section 1442 provides that payments to foreign corporations are also subject to withholding. FDAP includes all amounts included in gross income, other than gains from the sale of property.
Here, the payments are an inducement for the issuer to enter into a sponsored ADR program with the DI. The payments are strictly consideration for the guarantee of exclusive distribution rights. In a sponsored program, the DI obtains the right to profit from the distribution of shares in the issuer in the U.S. market without competition from other DIs. Inherent in this right is the right to benefit from the use of the issuer's trade name and reputation in marketing the ADRs. These rights, the service observed, represent an interest in intangible property.
A payment made for the right to use an intangible property right is a royalty. Under Section 861(a)(4), royalties for the privilege of using patents, copyrights, franchises, and "other like property" in the United States constitutes U.S. source income. The rights obtained from the issuer under a sponsored ADR program are similar to a franchise arrangement for the distribution of a product within a given marketplace.
Thus, the service concluded, payments under a sponsored ADR program should fall within "other like property" for purposes of Section 861(a)(4). Accordingly, the payments constitute income from sources within the United States. The payments are U.S. source FDAP and, therefore, are subject to withholding, unless the issuer is engaged in a business in the United States.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.