Taxes, International Clienteles and the Value of ADR Dividends

• Author: Graham H. Partington,Aelee Jun
• Published date: 01 November 2014
• DOI: http://doi.org/10.1111/jbfa.12088
• Date: 01 November 2014

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 41(9) & (10), 1337–1360, November/December 2014, 0306-686X

doi: 10.1111/jbfa.12088

Taxes, International Clienteles and the

Value of ADR Dividends

AELEE JUN AND GRAHAM H. PARTINGTON∗

Abstract: An alternative approach to valuing dividends is developed and applied to American

Depositary Receipts (ADRs) on Australian stocks. The values of ADR dividends are estimated

from the period when, due to different ex-dividend dates, the ADRs and their underlying stocks

trade with differential dividend entitlements. Australian ADR dividends are valued at less than

their face value and the dividends on the underlying stocks are valued at more than their face

value. This suggests that ADR dividends are priced by a clientele of US investors placing little

value on the imputation tax credits attached to the dividends and that a clientele of Australian

resident investors, who obtain value from imputation tax credits, price the dividends on the

underlying stock.

Keywords: Dividends, ADR, clienteles, imputation, taxes

1. INTRODUCTION

This paper provides an alternative approach to estimating the value of dividends. The

method is applied to American Depositary Receipts (ADRs) written on Australian

stocks. ADRs are designed to replicate the underlying stocks. In general, therefore,

the prices of the two securities are not expected to differ significantly. However, the

ex-dividend date in the domestic market can differ from the ex-dividend date in the

ADR market. In this situation the ADR price and the stock price are expected to

diverge due to their different dividend entitlement. Observing the price difference

between the two markets, over the differential entitlement period, provides an

alternative approach to estimating the market value of dividends.

We call the price difference divided by the dividend, the dividend valuation ratio,

or DVR. We illustrate the analysis of the DVR using Australian data, but the technique

can be applied to any country where ADRs, or Global Depositary Receipts (GDRs),

and the underlying stock go ex-dividend on different dates. In the Australian case it is

∗The first author is from the School of Accounting, Economics and Finance, Faculty of Business, University

of Wollongong, Australia. The second author is from the Finance Discipline, School of Business, University

of Sydney. The authors would like to thank the Capital Markets Co-operative Research Centre (CMCRC)

for supporting this research and the Securities Industry Research Centre of Asia-Pacific (SIRCA) for the

provision of the data used in this study.The authors are also grateful to the anonymous referee who provided

helpful comments and suggestions.

Address for correspondence: Graham H. Partington, Finance Discipline, School of Business, University of

Sydney, NSW 2006, Australia.

e-mail: graham.partington@sydney.edu.au

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the home market that goes ex-dividend before the ADR market, so the difference in

price reflects the value of the ADR dividend. In the case of Hong Kong, it is the ADR

market that goes ex-dividend before the home market (Kadapakkam et al., 2010). In

this case the DVR would give the value of the dividend on the underlying stock trading

in Hong Kong.

The valuation of dividends has been a subject of extensive debate since Miller and

Modigliani (1961). It is also a substantive issue since it is relevant to company dividend

policy, company valuation and the cost of capital. A significant contribution of this

paper, therefore, is in providing an alternative method for valuing dividends. One

advantage of the method is that rather than a single observation of the ex-dividend

price difference, as in a traditional ex-dividend study, more than one observation may

be possible for each ex-dividend event. One disadvantage of the method is that it can

only be applied to stocks that trade as ADRs or GDRs.

Studies of ADRs provide an opportunity to examine the effect of taxes on dividend

valuations across countries and tax regimes. However, ex-dividend studies of ADRs and

the underlying stocks provide conflicting results on whether it is the tax regime in the

home market, or the tax regime in the US that dominates the valuation of dividends

on ADRs. For ADRs on Hong Kong stocks, an ex-dividend study by Kadapakkam et al.

(2010) finds evidence consistent with the ADR dividend being valued as though it

was untaxed, as is the case for dividends on the underlying stocks traded in Hong

Kong. For ADRs on Australian stocks an ex-dividend study by Jun et al. (2008) finds

the reverse result. Dividend valuations appear to be dominated by the Australian tax

regime in the home market, but not in the ADR market. However, as discussed in

section 3, Kadapakkam et al. (2010) use a set of control variables and it is an open

question whether the results of Jun et al. (2008) are robust to the application of

similar controls. By analysing the valuation of Australian ADR dividends using our

new approach, using similar controls to Kadapakkam et al. (2010) and using a larger

dataset, we find the results of Jun et al. (2008) to be robust. Triangulating the results

from Jun et al.’s traditional ex-dividend study is one of the contributions of this study.1

Callaghan and Barry (2003) provide evidence consistent with foreign taxes on ADR

dividend income leading to abnormal ex-dividend day volume, which they interpret

as dividend avoidance trading by US investors. As we explain below, US investors in

Australian stocks do not generally face the withholding tax problem that Callaghan

and Barry (2003) address. However, tax effects are expected to lead to differences

in value between the ADR and the underlying stock. This is because of substantial

differences in the taxation of dividends between the US and Australian markets.

Australia operates an imputation system in which Australian resident shareholders are

entitled to receive tax credits, which are called franking credits. These franking credits

are equal to the Australian corporate tax paid on the profits from which the dividend

has been distributed.

Dividends may be fully franked, partially franked or unfranked, corresponding

to profits having been fully taxed, partially taxed or not taxed at the prevailing

Australian corporate tax rate. To the extent that ADR dividends are franked, US

holders of ADRs are exempt from Australian withholding tax, but they are not

otherwise entitled to claim franking credits. The withholding tax rate was 15% and

1 Unfortunately, since stocks in the Hong Kong market go ex-dividend after their ADRs it is not possible,

using our method, to triangulate the ADR results for Kadapakkam et al. (2010).

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