That is because brokerage
firms often lend stock held in these accounts to other investors, such as hedge
funds, that make bearish bets. This has no impact on an investor's ability to
sell stocks in his or her account. But such an investor doesn't receive the
dividends paid on stocks that are lent out. These go to the borrower, who then
reimburses the investor an amount of money equal to the dividend.
Brokerage firms that don't want to discourage customers from investing on margin
will have to decide whether to stop lending out stock in these accounts, at
least over dividend record dates, or come up with some way to compensate clients
who incur a higher tax rate on payments made in lieu of dividends.
Some brokerage firms lend out more stock to short sellers than others, so an
investor's chance of receiving a payment in lieu of a dividend, rather than a
dividend, depends on where he or she has a margin account.
NEW YORK -- Investors who own stock in a margin account may be in for
an unpleasant surprise: The dividends they receive may not be eligible for the
new, lower tax rate.
That is because brokerage firms often lend stock held in these accounts to other investors, such as hedge funds, that make bearish bets. This has no impact on an investor's ability to sell stocks in his or her account. But such an investor doesn't receive the dividends paid on stocks that are lent out. These go to the borrower, who then reimburses the investor an amount of money equal to the dividend.
In the past, investors were largely indifferent to whether they received a dividend or what is called a "payment in lieu of a dividend," since both were subject to the same tax rate. Indeed, brokerage firms don't distinguish between the two in account statements or on tax forms, so investors generally aren't even aware when their stock is lent out.
But the tax package signed into law last month discriminates between dividends, which are taxed at a maximum rate of 15%, and payments in lieu of dividends, which are taxed at ordinary income rates of as much as 35%.
Since the dividend tax cut is retroactive to Jan. 1, investors who thought they received dividends earlier this year, and expect to be subject to the lower tax rate, may actually be subject to the higher rate if their stock was on loan when the dividend was paid.
The distinction is only relevant to investors with margin accounts, which allow them to purchase stock with money borrowed from the brokerage firm. Brokerage firms generally don't lend stock held by customers in ordinary accounts.
The Securities Industry Association, Wall Street's trade group, has published a brochure to help member firms educate clients about the impact of the tax package. Available on the group's Web site at www .sia.com, it includes a section on the treatment of payments made in lieu of dividends. "This is a complicated concept to understand, but an important one," the brochure says. It urges investors to talk to their financial consultants for details.
Tax experts say investors probably don't need to worry about 2003 returns. It is up to the Treasury Department to publish rules interpreting the tax package, but Congress has asked that the penalty be waived for investors who claim the lower tax rate this year when they unknowingly received a payment in lieu of a dividend.
In the meantime, brokerage firms will have to put new systems in place to tell clients whether they have received dividends or payments in lieu of a dividend. SIA spokesman Dan Michaelis said he didn't know how long this would take, but it's "going to involve some effort."
However, one industry observer noted that brokerage firms already have systems in place to notify corporate clients when stock held in their accounts is lent out over a dividend-record date. Adapting the systems to notify individual investors might not take more than a few weeks, this person said.
Brokerage firms that don't want to discourage customers from investing on margin will have to decide whether to stop lending out stock in these accounts, at least over dividend record dates, or come up with some way to compensate clients who incur a higher tax rate on payments made in lieu of dividends.
"I don't think a brokerage firm will indiscriminately borrow from individual accounts and surprise them" with a bigger tax bill, said Charles Pomo, head of the individual tax practice at Geller & Co., a New York accounting firm. "The only way to make it equitable is to compensate investors for it or look more to nontaxable accounts" for stock loans, he said.
Mr. Michaelis, the SIA spokesman, said he doesn't know which approach members will take. "This raises a lot of questions," he said.
Some brokerage firms lend out more stock to short sellers than others, so an investor's chance of receiving a payment in lieu of a dividend, rather than a dividend, depends on where he or she has a margin account.
For example, Edward Jones, a regional broker-dealer based in St. Louis, has about $2 billion in margin loans to customers outstanding, but less than $10 million of stock held in these accounts is lent to short sellers, according to Jeff Orf, manager of settlement and trades.
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