Prior to the Jobs and Growth Tax Relief Reconciliation Act of 2003, which was signed into law by President George W. Bush on May 28, 2003, the following discussion was a non-issue due to the non-preferential tax treatment on dividends prior to that date, but has become an important issue since the new law which reduced the federal tax rate to a maximum of 15% for “qualified dividends” came into effect.
It is important to note that investors who hold dividend-paying stock in a margin account might be, unwittingly, working against their own best interests, for two reasons. One, which Jim Puplava and his roundtable guests so clearly pointed out on Financial Sense Newshour radio program this past weekend in, "Silver Stocks - Fraud or Manipulation?", is that investors are providing the ammunition for short-sellers to bring down the price of their shares by enabling the act of short-selling, and two, when a dividend is paid during the period the shares have been shorted the investor will not receive a “dividend” from the corporation.
Instead, the investor will receive a substitute payment “in lieu” of a dividend payment (the buyer of the shorted shares receives the qualified dividend from the company – there can not be two sets of qualified dividends on the same share). “In lieu” of payments do not qualify for the lower 15% tax rate afforded qualified dividends. Instead, such payments are taxed as ordinary income as high as 35%. The investor essentially gives up 20% of the dividend. As more and more gold/silver companies begin to pay out cash dividends, this will become a very important issue going forward -- assuming the preferential tax treatment on dividends remains in effect post-2012, when the Bush tax cuts may expire or be amended in some fashion.
The practice of loaning out shares to short-sellers is so lucrative that some brokers do provide a credit adjustment for their customers in order to reduce any potential negative impact this "in lieu" payment may have, by providing a “grossed-up” payment to cover any potential tax shortfall. However, this is not standard practice and at the broker’s discretion.
The bottom line is that shareholders who do not wish for their shares to be available to short-sellers need to ensure their brokerage accounts reflect this intention.