Depositary Receipts Program Payments

Transcription

1 IRS Releases Chief Counsel Memorandum Applying Withholding Tax to Payments Made to a Non-U.S. Corporate Issuer Participating in a Sponsored American Depositary Receipts Program SUMMARY On December 17, 2010, the Internal Revenue Service (the IRS ) released a Memorandum from the Office of Chief Counsel (the Memo ), concluding that (i) payments by a U.S. depositary institution (the Depositary ) to a foreign corporate issuer (the Issuer ) reimbursing the Issuer for various expenses incurred in relation to a sponsored American Depositary Receipts ( ADR ) program are includible in the gross income of the Issuer; and (ii) such payments to the Issuer are subject to withholding under Section BACKGROUND Non-U.S. Issuers frequently participate in ADR programs in order to make their stock more accessible to U.S. investors. An ADR of an Issuer represents ownership in one or more shares, or a fraction of a share of the Issuer s stock. The ADR is priced in U.S. dollars and the Depositary pays dividend-equivalent payments in U.S. dollars based on dividends it receives in foreign currency from the Issuer. The ADRs are traded like the shares of a U.S.-based company on U.S. exchanges and over-the-counter markets. The ADRs help to meet the needs of U.S. investors that want to invest easily in foreign companies, without the inconveniences of cross-border or cross-currency transactions. In a sponsored ADR program, the Issuer registers with the Securities and Exchange Commission and chooses an exclusive Depositary. In an unsponsored ADR program, the Issuer does not agree to use an exclusive Depositary, and any Depositary can acquire the Issuer s stock and offer ADRs to U.S. investors. The Memo pertains solely to payments to Issuer in a sponsored program. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 An Issuer will incur various expenses in relation to a sponsored ADR program. It is common for a Depositary to pay a portion of these expenses. 1 Payments are usually made after the Issuer presents, within a specified time, acceptable documentation substantiating payment by the Issuer of the ADR program-related fees or expenses. The Depositary may make payments on behalf of the Issuer to thirdparty vendors, or it may make payments directly to the Issuer. The expenses of the Issuer that the Depositary agrees to pay are typically subject to a cap and must be of the kind that the Issuer would not have incurred but for participating in the ADR program. The Issuer s operating costs, such as salary or overhead expenses, are generally not paid by the Depositary. THE MEMO The Memo concludes that payments from a Depositary to an Issuer are includible in the Issuer s gross income and subject to withholding under Section While the Memo was issued to provide guidance to IRS agents and is not binding precedent in a court proceeding, it is significant because it indicates the IRS s positions on such payments and is considered authority 3 for the purposes of determining whether a taxpayer s treatment of an item on the tax return is or was supported by substantial authority. 4 Payments Includible In Gross Income The Memo reviews existing case law and explains that the critical question is whether the expenses reimbursed by the Depositary are expenses of the Issuer or expenses incurred by the Issuer on behalf of the Depositary. If the latter, the payments would not constitute income of the Issuer. However, the Memo determines that the reimbursed expenses are actually expenses of the Issuer based on the following key factors: the payments are for expenses any Issuer would expect to incur to sell its stock in the U.S.; the Depositary does not have a pre-existing obligation to incur these expenses, the source of its obligation being solely by virtue of its agreement with the Issuer; the Issuer has discretion over which accounting firm, law firm, vendor, or other supplier to use in instituting its ADR program when it incurs the expenses; Such expenses include legal fees, accounting fees, SEC registration costs, marketing expenses, expenses for participating in investor conventions, costs for acquiring and maintaining electronic communications systems, exchange and listing fees, filing fees, underwriting fees, mailing and printing costs in connection with sending out financial reports, annual reports, proxy mailings, and other administrative costs. Unless otherwise noted, all Section references contained in this publication are to the Internal Revenue Code of 1986, as amended (the Code ). Treasury Regulation Section (d)(3)(iii). A 20 percent accuracy-related penalty applies to the portion of an underpayment that is attributable to a substantial understatement of income tax. Section 6662(d). A taxpayer may avoid such substantial understatement penalty attributable to any item on the tax return if the taxpayer s treatment of that item on the return is or was supported by substantial authority. Section 6662(d)(2)(B)(i) and Treasury Regulation Section (d)(1). -2-

3 the Depositary does not pay all of the expenses necessary to set up the ADR program, but only up to an agreed or capped amount, leaving the balance payable by the Issuer; and the Depositary has not paid any direct consideration for the exclusive right to serve as the Depositary for the Issuer s ADR program, which suggests that the Depositary s payments of the Issuer s expenses are intended to compensate the Issuer for its agreement to deal exclusively with the Depositary. On that basis, the Memo determines that the reimbursed expenses primarily benefit the Issuer and not the Depositary and, accordingly, concludes that the payments are income of the Issuer. However, we note that the Memo explicitly does not address the tax treatment of a waiver of fees the Depositary might otherwise charge Issuers, so Issuers should consider whether it is advisable to structure Depositary fee arrangements so as to minimize actual payments made by the Depositary. Payments Subject to Withholding Section 1441 generally requires any person making a payment of U.S. source fixed or determinable annual or periodical income ( FDAP ) to a nonresident alien to withhold from the payment a tax equal to 30 percent, unless such tax rate is reduced by a provision of the Code or a treaty or the income is effectively connected with a U.S. trade or business. Section 1442 provides that payments to foreign corporations are subject to withholding taxes in the manner provided under Section FDAP includes all amounts included in gross income under Section 61 other than gains from the sale of property. 5 The Memo concludes that 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, 6 and thus the ADR program payment is U.S. source income under Section 861(a)(4) because it is a royalty for the privilege of using patents, copyrights, secret processes and formulas, good will, trade-marks, trade brands, franchises, and other like property in the U.S. Because the ADR program payments are U.S. source and not otherwise exempt from withholding, they are subject to the 30 percent withholding tax required under Section 1442, unless the Issuer is engaged in a trade or business in the United States or that amount is otherwise reduced by an income tax treaty between the U.S. and the country in which the Issuer receiving the payment resides. Because these payments do not fall clearly within a customarily recognized class of income (such as interest or dividend) that is described in most treaties, each treaty 5 6 Treasury Regulation Section (b). The Memo reasoned that (1) such payments are strictly consideration for the guarantee of exclusive distribution rights so that the Depositary obtains, for a period of time, the right to profit from the distribution of shares in the Issuer in the U.S. market without competition from other Depositaries, and that (2) inherent in this right is also the right to benefit from the use of the Issuer s trade name and reputation in marketing the ADRs. -3-

4 might be applied differently. Furthermore, even where different treaties class these payments as the same type of income, the treatment under the treaties may be different. 7 * * * Copyright Sullivan & Cromwell LLP For example, if the ADR payments are classed as Other Income, there would be no withholding tax under the UK-U.S. treaty, but withholding tax would apply under the Australia-U.S. treaty. -4-

5 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 800 lawyers on four continents, with four offices in the United States, including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish ( ; rishj@sullcrom.com) or Alison Alifano ( ; alifanoa@sullcrom.com) in our New York office. CONTACTS New York Ronald E. Creamer, Jr creamerr@sullcrom.com Vivian Y. Ouyang ouyangy@sullcrom.com London S. Eric Wang wangs@sullcrom.com SC1: