In today's world of multinational dominance and rapid globalization, investors can buy shares of foreign companies quite easily. For U.S. investors, these shares typically come in the form of American depositary receipts, or ADRs. What is an ADR, you ask? Though these special stocks are quite common, they are not exactly the same as domestic shares of American companies. Today we'll learn what investors need to know about ADRs before buying foreign stocks.

foreign currencies

Image source: Getty Images.

What is an ADR?
An ADR is essentially a certificate issued by an American bank that represents a certain number of shares of foreign stock. It's worth noting that even stocks that look and sound American and trade on the New York Stock Exchange can be ADRs.

These certificates and the number of ordinary shares of the foreign company they represent can vary widely. For example, one ADR for Anheuser-Busch InBev represents one share in the company, but one ADR for Diageo represents four ordinary shares in the company. Before you make a purchase, be sure to look up your company on one of two ADR-specific websites operated by JPMorgan or BNY Mellon so you know exactly what you are buying.

How do I know if a stock is an ADR?
Sometimes when you search for a stock on a finance website, you'll notice a handful of extra letters at the end of its official name -- for example, Anheuser-Busch InBev SA/NV. These letters are essentially the foreign equivalent of "Inc.," "Corp.," or "publicly traded company." These foreign acronyms might tip you off to the fact that a stock is an ADR, but this doesn't work in every case. For example, Honda Motor does not have a foreign suffix yet is also an ADR.

That's why the best way to make absolutely certain a stock is an ADR is to look it up on one of the aforementioned ADR sites. Simply key in your ticker or company name in the search field and hit enter. If your company comes up, it's an ADR; if it doesn't, it's not. Pretty simple.

Are all ADRs the same?
Most of the reputable foreign stocks you'll come across will be one of two types of ADRs. Level I ADRs refer to companies trading their shares "over the counter." Their shares are often referred to as "pink sheets." You'll see this with companies like Heineken or Volkswagen, and it simply means they have chosen not to list their ADRs on American exchanges. Level II and Level III ADRs, like Alcatel Lucent and Toyota, are ADRs that do trade on American exchanges like the New York Stock Exchange or NASDAQ. This subjects them to full reporting with the SEC. Level I ADRs report to FINRA and are not required to submit to full registration with the SEC.

What about taxes?
ADRs can get a little tricky when it comes to taxes on the dividends. Remember that you are essentially investing your money in a foreign country when you buy them, and each country has varying approaches to taxation. In certain situations, the withholding tax may completely eradicate the benefit of the dividend. Therefore it makes sense to look into the withholding tax rates for your particular security. You can find a list of such rates here.

That said, if foreign dividends are a significant part of your investment strategy, it would be a good idea to consult a tax advisor or a representative at your bank or brokerage to find out exactly how the dividend tax scenario will play out for your particular security.

Bottom line
Buying foreign-based companies can add a new dimension to your portfolio, but they do require a little bit more work in the beginning, especially when it comes to taxes. Ultimately, it's more important than ever to know exactly what you're getting when it comes to buying foreign stocks.