ADR vs. ADS: Key Differences in Structure and Investor Benefits

Investors looking to access foreign stocks without dealing with international exchanges often turn to American Depositary Receipts (ADRs) and American Depositary Shares (ADSs). These instruments allow U.S. investors to buy shares of non-U.S. companies more conveniently, but the terms ADR and ADS are sometimes used interchangeably, leading to confusion.

While both serve as a bridge between foreign companies and U.S. markets, they have structural differences that impact how they function and what investors should consider when trading them.

Formation and Underlying Share Representation

ADRs and ADSs are created when a foreign company partners with a U.S. depositary bank. The company issues ordinary shares in its home market, which a custodian bank holds. Based on these shares, the depositary bank issues ADSs, which represent ownership in the foreign company and trade in the U.S. market. The ADR itself is the certificate—physical or electronic—that evidences ADS holdings.

Each ADS corresponds to a specific number of foreign shares, which varies depending on the structure set by the issuing company and the depositary bank. Some ADSs represent a single foreign share, while others bundle multiple shares into one ADS to create a more accessible price point. For example, a company with a high share price in its home market might structure its ADSs so that one ADS represents a fraction of a single foreign share, making it more comparable to U.S. stock prices.

The ratio between ADSs and the underlying shares is determined by liquidity, investor demand, and regulatory considerations. A 1:1 ratio is common, but ratios like 5:1 or 10:1 help align the ADS price with typical U.S. stock valuations. This structuring ensures ADSs remain attractive to investors while maintaining consistency with the foreign company’s share price movements.

Trading and Market Access

ADRs and ADSs allow foreign companies to reach U.S. investors without listing their shares directly on American exchanges. These instruments trade on major U.S. stock markets like the New York Stock Exchange (NYSE) and Nasdaq or over-the-counter (OTC), depending on the level of regulatory compliance the issuing company is willing to meet. Exchange-listed ADRs must adhere to Securities and Exchange Commission (SEC) reporting and disclosure requirements, while OTC-traded ADRs generally have fewer regulatory obligations but may carry higher risks due to lower liquidity and transparency.

The level at which an ADR trades depends on the company’s SEC compliance. Level I ADRs, the most basic form, trade only on the OTC market and have minimal reporting requirements. Level II ADRs are listed on major exchanges and must meet stricter disclosure standards, including filing annual reports using Form 20-F, which aligns with U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Level III ADRs allow foreign companies to raise capital directly from U.S. investors through public offerings, requiring full SEC registration and extensive financial reporting.

Liquidity varies significantly between ADRs based on the company’s size, investor interest, and trading volume. Heavily traded ADRs, such as those of multinational corporations like Alibaba or Toyota, tend to have tighter bid-ask spreads and higher daily volumes, making them easier to buy and sell. In contrast, ADRs of smaller or less well-known companies may experience wider spreads and lower trading activity, leading to higher transaction costs.

Currency fluctuations also affect ADR pricing since the underlying shares are denominated in a foreign currency. When exchange rates shift, the ADR’s value adjusts accordingly, even if the stock price in the home market remains unchanged. A strengthening U.S. dollar can reduce the ADR’s value, while a weakening dollar can enhance returns. Some depositary banks offer currency hedging options, though these typically come with additional costs.

Shareholder Rights

ADRs provide investors with rights similar to those of shareholders in the foreign company, but certain limitations exist due to the depositary bank’s intermediary role. Instead of directly owning the underlying foreign shares, ADR holders have a beneficial interest, meaning their rights are exercised through the depositary. This affects voting rights, dividend distribution, and corporate actions, depending on the deposit agreement between the foreign company and the depositary bank.

Voting rights for ADR holders are often restricted. While many ADR programs allow investors to vote on corporate matters such as board elections and mergers, the process is not always straightforward. The depositary bank receives voting instructions from the foreign company and passes them on to ADR holders, who must submit their votes within a set timeframe. However, if the depositary does not receive clear instructions, it may choose not to pass voting rights to ADR holders at all. Some companies explicitly limit or exclude voting rights for ADR investors, making it essential to review the deposit agreement.

Corporate actions, such as stock splits, rights offerings, and tender offers, may also be handled differently for ADR holders. In a rights offering, where a company issues new shares to existing investors at a discounted price, ADR holders may not always have the ability to purchase these shares directly. Instead, the depositary bank might sell the rights in the open market and distribute the proceeds to ADR investors, which can be less favorable than exercising the rights themselves. Similarly, stock dividends or bonus shares may be converted into cash rather than distributed as additional ADRs, depending on the policies set by the issuing company and the depositary bank.

Tax Treatment and Withholding

ADR investors are subject to tax obligations in both the U.S. and the foreign country where the underlying company is based. One key consideration is foreign withholding tax on dividends. Many countries impose a tax on dividend payments before they reach ADR holders, with rates varying widely. For example, Germany levies a 26.375% withholding tax, while the United Kingdom does not impose one on most dividends. These taxes are deducted at the source, meaning investors receive a reduced dividend amount.

To mitigate double taxation, the U.S. allows ADR investors to claim a Foreign Tax Credit (FTC) on their federal tax returns, reducing their U.S. tax liability by the amount already paid to the foreign government. However, the credit is subject to limitations. If the foreign tax exceeds the U.S. tax rate on dividends, any excess may not be immediately refundable but can be carried forward for future use. Investors must file Form 1116 with the IRS to claim this credit, which requires detailed documentation of foreign tax paid.

Capital gains taxation depends on how long the ADR is held. Gains from ADR sales are taxed at the same rates as domestic stocks—short-term gains (held for one year or less) are taxed at ordinary income rates ranging from 10% to 37%, while long-term gains benefit from lower rates of 0%, 15%, or 20%, depending on taxable income. However, some countries impose capital gains tax on non-residents, creating additional tax liabilities for ADR holders.

Regulatory Filing Obligations

Foreign companies issuing ADRs must comply with U.S. regulatory requirements, which vary depending on the type of ADR program they establish. These obligations influence the level of transparency investors receive and the extent to which the company must adhere to U.S. securities laws.

For ADRs listed on major exchanges, companies must register with the SEC and file periodic reports, including annual financial statements on Form 20-F. This form requires reconciliation to either U.S. GAAP or IFRS, ensuring financial disclosures align with American investor expectations. Companies with Level III ADRs, which involve capital-raising activities, face the most stringent reporting requirements, including quarterly filings and compliance with Sarbanes-Oxley Act provisions. In contrast, Level I ADRs, which trade OTC, have minimal disclosure requirements and are exempt from full SEC registration. While this reduces regulatory burdens for the issuing company, it also means investors may have limited access to financial data, increasing risk.

Beyond SEC filings, ADR issuers must adhere to corporate governance standards set by the exchange where they are listed. Nasdaq and NYSE, for example, impose rules regarding board composition, audit committee independence, and shareholder communication. Companies that fail to meet these standards risk delisting, which can reduce liquidity and investor confidence.

Dividend Handling Mechanisms

Dividend payments on ADRs must be converted from the foreign company’s currency into U.S. dollars before reaching investors. The depositary bank handles the receipt, conversion, and distribution of dividends while deducting applicable fees and taxes.

Exchange rate fluctuations affect the final dividend amount. Since dividends are declared in the foreign company’s local currency, any depreciation against the U.S. dollar reduces the payout, while appreciation increases it. The depositary bank typically converts dividends at prevailing market rates but may apply a small spread, slightly lowering the amount distributed to investors. Processing fees—often ranging from $0.01 to $0.05 per ADR—are also deducted before payments are credited to investor accounts.