Securities lending in its core is a simple transaction. The owner of a security (e.g. stock in a listed company) wants to stay invested in it, but is willing to lend it to someone else for a certain period, as long as he will get his security back and gets something extra in return for lending the security. To make sure that he will get his securities back, he will also ask for something valuable as collateral.

The owner of the security knows that when he lends his securities to someone else, the other person will get the (stock)dividends or voting rights that come with those securities if the other 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 when they are lent.

The borrower immediately becomes the legal owner of the securities and may do with them whatever he pleases. If he for instance chooses to sell the securities in the market (or has already sold them and now still has to deliver) because he anticipates that the price is going down, so that he can buy them back later at a lower price (and return them to the lender), he is also free to do that.

The thing with securities is that they are what is called “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.

The borrower of securities thus becomes the owner of the securities and has an obligation to deliver equivalent securities at the end of the term.

When the investor lends its securities in a period when a dividend is being paid, he is no longer the owner of the security and so he 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.

Tax

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 simple. The borrower would get the net (after-tax) dividend and he would use it to compensate the lender. The lender gets the same amount as when he would not have lent the securities so he is at just as well off as when he had not lent his securities.

In reality, while withholding tax looks like it is just one flat tax rate it isn’t. The effective rates usually differ depending on who the owner of the security is 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 its activities (e.g. being a pension institution, as pension institutions are often entitled to lower rates or (partial) refunds).

You can imagine that 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 low (or lower) tax.

If we go back to the lender, he should be compensated for the dividend he misses taking into account his own after-tax position when he would not have lent his securities. For example, if the lender would face 20% dividend tax, he wants to receive at least 80% of the dividend from a borrower. In addition the lender will normally want a fee for lending his securities.

If the borrower would face a higher dividend tax than the original investor, he would have to pay a higher amount in substitute dividend than what he receives in actual dividend. On the other hand, if he ultimately faces a lower dividend tax than what he needs to pay to the original investor, he would have an advantage that for instance enables him to pay the borrower some fees and make a profit.

It is clear that the difference in withholding tax treatment creates room for “tax arbitrage”.

In a simple theoretic economic optimum, securities would tend to transfer to parties that face a lower dividend tax than the original investors just before a taxable dividend is being paid. This is especially true because the applicable dividend tax is usually determined in one particular instance, rather than throughout a period (it is an event based tax, not an accrual tax). Using one instance instead of a period saves a huge administrative burden. Especially when securities are frequently traded.

Many authorities tend to consider transactions that are only in place to seek a withholding tax optimum as undesired. If a party merely acts as a cashier with a better tax profile, chances are these situations are countered with complex anti-abuse legislation in place. The difficulty here however is that these rules can be very technical and do not (adequately) take into account legitimate stock rotation. Also, arbitrage may not always be very visible resulting in legislation that also impacts real security transfers.

We see more and more often that the entitlement to tax benefits (which are determined on a particular day) are assessed by local authorities also taking 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 asses if a claim for benefits is “legitimate” or not.

If we again look at a securities lending transaction in which stock transfers from the original investor to a borrower, just before dividend, with the purpose to make use of a difference in 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 with a million reasons other than seeking a tax optimum (rebalancing portfolio’s, inflows, outflows etc.) are confronted with demonstrating their holding periods for securities to demonstrate 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 are at odds 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 can very well be a long term investor that can freely dispose of the dividends.

Some practical considerations

• When participating in a securities lending program, make sure that you do not only consider your net (after tax) dividend position in relation to a specific portfolio and investment country, but also make sure that you know whether you are entitled to a (partial) credit for tax incurred that you lose if you don’t receive the actual dividend but a substitute payment.

• When you are in a securities lending program, additional tax recovery can become more complex because your income is ‘tainted’: you will have received some substitute dividend amounts, which are not actual dividends. This means that no dividend tax was withheld at your direct expense, so you are also not entitled to reclaim, or offset the withholding tax. You will need to scrub your dividend income from any substitute or manufactured dividends before reclaiming dividend tax.

• Note that some jurisdictions (like Switzerland) take the opposite approach and will allow the original owner (lender) of a security, not the borrower, to claim the tax benefits, but this may require quite a bit of paper work. Make sure you understand your position.

• Securities lending is often associated with dividend tax arbitrage. If you lend out your securities you may potentially lend them to someone who has a better tax position than yourself. This however is not necessarily the case.

• Purchasing stock closer towards a dividend pay date may in some jurisdictions create additional obstacles in claiming tax benefits.