The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) introduced qualified dividends, a new category of dividend income, taxable at federal rates lower than those applicable to ordinary income. See Qualified Dividends. The rates on substitute payments distributed in lieu of qualified dividends, however, remain unchanged. Therefore, beginning in calendar year 2005 Fidelity started providing eligible margin customers with an annual credit adjustment to help offset the additional tax burden (if any) associated with substitute payments in lieu of qualified dividends.¹
The following FAQs are intended to clarify what substitute payments are, when they might be made, and what the tax consequences of receiving them could be.
What are substitute payments and how are they taxed?
Substitute payments in lieu of dividends may be generated where, for example, a security has been lent to a third party (such as a broker) over a dividend record date. If an investor has a margin account debit balance, securities in the account are often eligible to be lent to a broker. If the shares are lent over a record date, the investor should receive a substitute payment equivalent in amount to the dividend but taxable at ordinary income tax rates. Prior to JGTRRA, substitute payments and actual dividends were both taxed at the federal level as ordinary income. JGTRRA introduced lower federal rates for qualified dividend income; however, substitute payments are not taxed as qualified dividend income and are instead still taxed as ordinary income (at federal rates as high as 35%). Substitute payments are reported in Box 8 of Form 1099–MISC.
If I have a margin account, what is the likelihood that my securities will be lent and that I will receive a substitute payment?
In order for a substitute payment to be generated, a customer must have a debit balance within a margin account, and shares on loan over a record date.
Fidelity may try to reduce the likelihood of substitute payments being generated by:
- Recalling dividend–paying stock loaned to third parties prior to record date, and/or,
- Refraining from loaning dividend–paying stocks over a record date.
Where will substitute payments be reported?
For 2010, Fidelity will report substitute payments in lieu of dividends or interest on line 8 of Form 1099–MISC.
If I am an individual taxpayer who receives a substitute payment and am required to pay taxes on the payment at ordinary income tax rates, will I suffer economically?
No, you shouldn’t suffer economically. If a substitute payment, in lieu of a qualified dividend, is received by an eligible customer, Fidelity currently intends to provide an annual credit adjustment to help cover any additional federal tax burden¹. Note, however, that Fidelity reserves the right to deny such payment to any customer which Fidelity determines will be ineligible to receive the tax benefit of the reduced qualified dividend tax rates.
What is the annual credit adjustment?
The annual credit adjustment is intended to compensate for the additional federal taxes that may be payable assuming that the substitute payment is taxable at the highest federal ordinary income tax rate of 35%, and the qualified dividend, which would have been otherwise received, is taxable at the highest federal qualified dividend tax rate of 15%. The annual credit adjustment will therefore be 30.77% of the substitute payment received in lieu of a qualified dividend.
Why isn't the adjustment 20%, the difference between the 15% and 35% rates?
The adjustment itself is potentially taxable. As such, the adjustment contains an internal adjustment on itself. The 30.77% payment reflects the adjustment on the adjustment. The adjustment is potentially reportable on a Form 1099–MISC (issued early in the year following the tax year in which the payment was made) in accordance with IRS rules.
When will Fidelity provide eligible customers with the adjustment?
Adjustments for substitute payments received during the 2010 calendar year will be paid in the first half of March 2011, or as soon thereafter, as all reclassification information is made available. The account receiving the substitute payment, or an eligible successor account, must be open at the time that adjustments are scheduled to be made in order to receive the adjustment.
When might a customer be eligible to receive the annual adjustment credit?
You may be eligible to receive the annual credit adjustment if:
- You are a U.S person (including U.S. citizens and resident aliens)
- You received the substitute payment in an account registered as individual, joint, trust, estate, or "pass–through" entity type (partnership, LLC, LLP, etc.)
- The account is open at the time credit adjustment is made; and
- You would have been eligible to treat (and report to the IRS) the dividend paid on the security on loan as a qualified dividend, had the security not been on loan and had you received the dividend paid on that security rather than the substitute payment in lieu of the dividend. (You will generally satisfy this condition if the applicable security is from a domestic corporation or a qualified foreign corporation, and you would have held the security unhedged for the requisite holding period for qualified dividend treatment.) See Qualified Dividends. Note that customers receiving certain substitute payments initially reported as potentially eligible for a credit adjustment may not be eligible for receipt of a credit adjustment as a result of a reclassification of the dividend that otherwise would have been received.
Fidelity reserves the right to amend the eligibility terms of the program.
For further information, call 1–800–FIDELITY.
