sarwesh

Clearly, when short-term interest rates increase from 2003 levels, the
attractiveness of securities lending should increase for dealers who create
and hold hedged positions in ETFs while lending the ETF shares to
short sellers. Their activity should assure a supply for ETF share borrowers.
However, an interesting change in the U.S. Federal Tax Code
will certainly change the dynamics of ETF securities lending and short
selling even if it does not change the economics very much.

The 2003 Tax Act, formally the Jobs and Growth Tax Relief Reconciliation
Act of 2003, cut the tax rate for individual investors on qualified
dividends from certain equity securities (including most ETFs) to
15%. The Internal Revenue Code distinguishes between various kinds
of dividend and interest income, on the one hand, and payments in lieu
of such dividend and interest income, on the other hand. This distinction
can be significant for municipal bonds, for example, where payments
in lieu of municipal interest are not exempt from federal and
certain state income taxes, while the actual interest payment or an interest
passthrough from municipal bond funds will qualify fully for tax
exemption. Similar provisions apply to Treasury interest, which is generally
exempt from state income taxes, but payments in lieu of Treasury
interest on securities lent out do not qualify for tax exemption.
Under the 2003 Tax Act, dividends can be affected by a similar distinction
between actual or passed-through dividends and payments in lieu
of dividends. Corporations have had to exercise care that the “dividends”
they have received on common and preferred stocks have qualified for
the tax code’s corporate tax dividend-received deduction by being actual
dividend payments or pass-throughs rather than payments in lieu. Most
individual investors have not had to worry about the character of such
payments until now. For 2003, the new tax act provides that as long as
an individual investor has no reason to believe that what he or she is
receiving is a payment in lieu, the taxpayer can assume dividend payments
from a brokerage firm or other custodian that holds the taxpayer’s
stocks, equity mutual funds or equity ETF shares are qualified dividends.
New Treasury rules dictate that financial intermediaries report dividend
48 THE MECHANICS OF SHORT SELLING


qualification status for 2004 and subsequent years. Payments in lieu of
ETF dividends from securities lenders will not qualify for the special dividend
tax rate in 2004 and later years. While some observers have suggested
that the lower dividend tax rate for individuals may increase the
cost of borrowing dividend-paying securities, it is more likely that there
will be a modest change in where the shares will be borrowed.
Some current ETF share lending may dry up. For example, brokers
carrying ETFs in individual investor’s accounts will not be able to certify
the ETF dividends as eligible for the 15% tax rate if they lend out the
shares. Institutional investors may have a more complex tax calculation to
make. Mutual funds, for example, often use ETFs to equitize small cash
balances. In fact, mutual funds probably account for a substantial fraction
of reported ETF institutional ownership.13 Some mutual funds may not be
willing to loan their ETF shares as freely in 2004 and later years because
any payment in lieu of dividends that they receive from the borrower will
not be distributable as qualifying dividends to their taxpaying individual
shareholders. However, the provisions of Internal Revenue Code § 854
will govern the eligibility of fund dividend distributions for the 15% tax
rate. This section was written to cover eligibility of dividends for the dividend-
received deduction and it, in effect, applies nonqualifying income to
expenses first, leaving qualified dividends to be distributed. Assuming the
same treatment under the new law, only funds with very low expense
ratios or very large share lending programs, will risk distributing payments
in lieu of dividends when they loan out ETF shares.


Any tax-exempt account will lend shares readily. Lending opportunities
might draw in the pension plans we described as potential ETF lenders in
the previous section. Long ETF positions held by a broker-dealer in its risk
management activities will be lendable because the broker-dealer cannot
take advantage of the special 15% dividend tax rate. Long positions held
by a dealer to hedge an equity swap transaction where the broker-dealer
pays the return on an ETF as a swap payment in return for receiving the
return on a stock position should also be lendable without incurring disadvantageous
tax treatment. The swap payments are already payments in lieu
and, hence, the position held by the dealer would be lendable without disturbing
any individual investor’s receipt of a qualified dividend.