At its core, securities lending is a simple transaction. The owner of a security (e.g. stock in a listed company) wants to keep their investment, but is willing to lend it to someone else for a certain period, with the guarantee they will get their security back in addition to something extra in return for lending the security. To ensure they will get their securities back, they will also ask for something valuable as collateral.
The owner of the security is aware that, by lending their securities to someone else, they will concede the (stock)dividends or voting rights that come with those securities to the other person, if said person still owns the securities on the dividend record date/ex date. Although you may think that the lender continues to be the legal owner of the securities, as would normally be the case when lending property, this is not the case.
In fact, the borrower immediately becomes the legal owner of the securities and may do with them whatever they please. If they, for instance, choose to sell the securities in the market (or have already sold them and now still have to deliver) because they anticipate the price going down so that they can buy them back later at a lower price (and return them to the lender), they are also free to do that. However, the borrower of the securities has the obligation to deliver equivalent securities at the end of the term.
One characteristic ofsecurities is that they are fungible. Just like when borrowing a cup of sugar to bake a cake, you can never return the exact same sugar you would have borrowed and put into the batter, but you can return the same type of sugar in the exact same amount.
When the investor lends its securities in a period when a dividend is being paid, they are no longer the owner of the security and so they will not receive the dividend. To make it economically worthwhile for him to lend his securities, he will thus ask the borrower to compensate him for the dividend as well. Assuming the borrower holds the shares, he will be entitled to the dividend, and passes an equivalent amount on (this is also called a substitute or manufactured dividend) to the lender.
Withholding tax and dividends
When the dividend is subject to withholding tax, it becomes a bit more complicated. If every owner of the security would always pay the same withholding tax it would be simpler: the borrower would get the net (after-tax) dividend and he would use it to compensate the lender. The lender would then get the same amount as if they had not lent the securities in the first place.
In reality, while withholding tax looks like it is just one flat tax rate, it is not. The effective rates usually differ depending on who owns the security at the moment the dividend is paid. These differences can be caused by a variety of things, such as the country of residency of an investor or the nature of its activities (e.g. being a pension institution, as pension institutions are often entitled to lower rates or (partial) refunds).
Therefore,if one investor is subject to a higher withholding tax on the same security as another investor, there is a potential advantage if securities are lent by investors that are subject to high tax to investors that are subject to lower tax rates.
On the other hand, the lender should be compensated for the dividend they have missed, taking into account their own after-tax position had they not lent their securities. For example, if the lender faces 20% dividend tax, they would want to receive at least 80% of the dividend from a borrower. Furthermore, the lender typically requires a fee for loaning out their securities.
If the borrower is subject to a higher dividend tax rate compared to the original investor, they would end up paying more in substitute dividend than they receive in actual dividend. Conversely, if the borrower faces a lower dividend tax rate than what they owe to the original investor, it provides an opportunity to pay fees to the borrower and generate a profit.
The difference in withholding tax treatment creates room for tax arbitrage.
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Tax arbitrage: what is it?
In a simple theoretical economic model, securities would transfer to parties subject to lower dividend tax than the original investors, just before the payment of taxable dividends. This is especially true because dividend taxes are usually assessed at particular instances rather than throughout a period (it is an event based tax, not an accrual tax). Using one instance instead of a period reduces administrative burdens significantly, particularly in the context of frequently traded securities.
Many authorities consider transactions that are only in place to seek a withholding tax optimum as undesirable. When a party merely acts as a conduit for tax optimization, such a scenario will often trigger the implementation of intricate anti-abuse legislation. However, the challenge lies in the technical nature of these regulations, which do not adequately take into account legitimate stock rotation practices. Moreover, arbitrage activities might not always be overt, leading to legislation that inadvertently affects genuine security transfers as well.
More and more often, the entitlement to tax benefits (which are determined on a particular day) is assessed by local authorities, who also take into account the holding period of a particular security that paid the dividend. The holding period (demonstrated on the basis of safekeeping account and transaction documentation) is then used as an indicator to assess if a claim for benefits is “legitimate” or not.
Looking at a securities lending transaction in which stock transfers from the original investor to a borrower just before dividend payout with the sole purpose of making use of a more convenient tax treatment, that transaction will likely be identified at the level of the borrower and assessed as not eligible for the benefit.
On the other hand large (fund) investors that continuously trade securities throughout the year for other reasons than seeking a tax optimum (rebalancing portfolios, inflows, outflows etc.) are forced to demonstrate their holding periods for securities to prove they are “legitimately” entitled to the dividends as well.
Although it is understandable that the holding reports can be an indicator of whether someone is a long term investor or is holding the security with the purpose of dividend arbitrage, these indicators create additional complexity to obtain benefits for legitimate investors and conflict with the fact that a dividend tax is an event based tax. An investor that buys a share one day before the relevant dividend date may very well be a long term investor with the ability to freely dispose of the dividends.
Some practical considerations
When engaging in a securities lending program, it's crucial to assess not only your net dividend position after taxes in relation to a particular portfolio and investment country, but also to determine whether you're entitled to a (partial) credit for incurred taxes, which you may forfeit if you receive a substitute payment instead of the actual dividend.
Participating in a securities lending program can complicate additional tax recovery because your income becomes 'tainted' due to receiving substitute dividend amounts instead of actual dividends. Consequently, no dividend tax is withheld at your direct expense, rendering you ineligible to reclaim or offset the withholding tax. Therefore, before reclaiming dividend tax, it is essential to separate your dividend income from any substitute or manufactured dividends.
It is worth noting that certain jurisdictions, such as Switzerland, adopt an opposite approach, allowing the original owner (lender) of a security rather than the borrower to claim the tax benefits. It's imperative to fully grasp your position and obligations in such cases, as this process may entail substantial paperwork.
