In more detail

ADR programs generally allow issuers access to US capital markets. The advice addresses only sponsored ADR programs, which provide exclusive arrangements between issuers and DI's. An issuer establishes a sponsored ADR program by entering into a deposit agreement with and appointing a DI (usually a US bank or trust company) as the exclusive depositary and agent for the issuance and other activities in respect of ADR for the issuer's stock in the United States. The DI generally serves three main functions, which are:

• To assist brokers by issuing and cancelling ADR that trade in the US capital markets
• To serve as the issuer's transfer agent in the United States (e.g., maintaining ADR holder records, disbursing dividend payments to ADR holders, and sending out proxy notices to ADR holders, etc.)
• To act as an administrator for the issuer by promoting ADR in the US capital markets. 

As an inducement to grant an exclusive arrangement for a sponsored ADR program, the DI generally offers to reimburse a portion of the expenses the issuer will incur in setting up the program or to revenue-share ADR fees with the issuer of the underlying stock (i.e., to pay the issuer a percentage of fees collected from ADR holders) ("ADR Program Payments").

Under section 881, a foreign corporation may be taxed at a flat 30% rate on gross income from US sources that is fixed or determinable annual or periodical (FDAP) income. Examples of FDAP income generally include interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments and other similar items. Section 861(a)(4) provides that rentals or royalties from property located in the United States or from any interest in such property, including royalties for the use of or for the privilege of using in the US patents, copyright, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other like property are treated as income from sources within the United States. Section 1442 requires any person making a payment of US source FDAP income to a foreign corporation to withhold from the payment a tax equal to 30%, unless such withholding rate is reduced or exempted under the Code or an income tax treaty or the income is effectively connected with the conduct of a US trade or business.

In determining whether the ADR program payments constitute FDAP income from sources within the United States that are subject to 30% withholding, the IRS first noted that the ADR program payments are remunerations to the issuer for providing the DI with the right to conduct business activities related to the ADR program in the United States. Next, the IRS noted that it is proper to treat the ADR program payments as having the character of payments for the use of property rights within the United States, because the ADR program, similar to franchise or other like property under section 861(a)(4), grants the DI exclusive right to establish, control, and exploit the trading of the issuer's ADR in the United States. Finally, the IRS noted that the United States is the place of use in this case and therefore is the source of the ADR program payments because the DI profits from holders trading in the US capital markets. Accordingly, the IRS concluded that the ADR program payments constitute FDAP income from sources within the United States, and, therefore, such payments are subject to 30% withholding under section 1441 unless treaty benefits apply.

However, in a previous advice memorandum (AM 2013-003), the IRS concluded that ADR program payments are not "royalties" under the narrow definition used in the US and OECD Model Treaties. Based on that analysis, the ADR program payments governed by a provision corresponding to either such Model Treaty would be treated as "Other Income." Therefore, if the issuer is eligible to claim the benefits of an income tax treaty with an "Other Income" provision and otherwise satisfies the requirements of any applicable "Limitation on Benefits" provision, no withholding is required on the ADR program payments. For instance, the Other Income provision (Article 22) of the US-UK Income Tax Treaty ("UK Treaty") is beneficial in that it provides that other income may only be taxed in the payee's (here, the issuer's) country of residence. Therefore, the ADR program payments are not subject to 30% withholding if the issuer is a UK resident and can also satisfy the requirements of the "Limitation on Benefits" provision of the UK Treaty. On the other hand, some treaties have unfavorable Other Income provisions. For example, the Other Income provision (Article 23) of the US-India Income Tax Treaty provides income earned in the US by a person resident in the other treaty jurisdiction that is not specifically addressed in the treaty may be taxed by the United States.

We recommend that DIs that act as ADR administrators assess their US withholding tax obligations if the counterparty issuers are not entitled to treaty benefits as mentioned above. Furthermore, the IRS could make similar arguments as those underlying the advice to assert withholding tax obligations in other cross-border expense reimbursement arrangements. Accordingly, US withholding agents should review their reimbursement agreements and policies to assess any potential exposure.