Not Everything Is Funny On The Back Page
By Gary Gastineau

Not Everything Is Funny On The Back Page

When Jim Wiandt asked me to fill in on this issue for Brad Zigler—the financial industry's No. 2 humorist (after Jim Cramer)—I initially declined. I am rarely inspired by a comic muse and it is hard to make humorous comments on financial topics these days without being morbid. However, after I spoke to Jim, I read his article, "Canaries in the Coal Mine" about exchange-traded fund short-selling activity in the Journal of Indexes' sister publication, ETFR. Lo and behold, Jim became my muse—though hardly a comic one—for the paragraphs that follow.

Short-selling is rarely of major significance to most ETF investors, but there is one issue related to short-selling that every individual investor holding ETFs should know about. Because once you know about it, you may want to take action to protect the income tax treatment of your ETF dividends.

Most ETFs distribute dividends that are largely or fully "qualified" for a reduced dividend tax rate. But a number of investors have mentioned to me that some of the qualified dividends paid by their ETFs have been categorized as payments in lieu of a dividend rather than as "qualified" dividends on the 1099 forms they receive from their brokers. The treatment of an ETF's entire annual dividend or a specific quarterly or monthly payout as a nonqualified dividend or a payment in lieu of a dividend usually happens because the investor's shares have been loaned to a short-seller over a period including the fund's dividend record date. Unfortunately, yelling at your broker after you get your 1099 will probably not prevent or compensate you for the cost of this "tax-enhancing" event.

Brokers have long been permitted to lend customer securities if the customer is using some of the services available in a margin account. Putting a security in a cash account usually prevents share lending. SEC Rule 15c3-3 describes the conditions on which brokers can lend shares from customer accounts if you want to do your own research. If you need to use a margin account for financing or for your own short-selling, you might consider asking the broker for written assurance that your shares will not be loaned or that you will be compensated for any adverse tax consequences if they are loaned. At least one brokerage firm indicates that it will attempt to make customers whole for adverse tax effects of a securities loan, but many firms explicitly state that they will not.

Even though there is a larger short interest in most ETFs than in most common stocks, an ETF position in an individual investor's account is not as attractive a candidate for broker lending as many small-cap stocks. However, the risk is not worth taking and, even if your 1099 shows that the dividends are qualified, there is some risk of receiving an amended 1099 long after you file your tax return. A friend of mine received an amended 1099 after he had filed a return treating an ETF dividend as qualified. In short, it is a good idea to deal with possible problems in advance.

This isn't to say that shorting is bad per se. The liberalization of the short-selling rules (Regulation SHO) is in the best interest of market efficiency and, more importantly, in the interest of investors generally. And though you might not know it based on the recent SEC prohibitions, short-selling is as American as apple pie—as long as the short-seller is not borrowing your dividend-paying shares.

Now I turn this column back over to alleged funnyman Zigler, who can continue his exercise in bestowing us with curmudgeonly wisdom.