As expected, the “qualified dividend” rules enacted last year have affected more than just the tax rate applicable to many dividends. The reduced tax rate on qualified dividends also has encouraged corporations to maintain or increase their dividend payments to investors.
In July 2004, Microsoft announced an increase in its dividend to US$.08 a share for its regular dividend payable Sept. 14, 2004, for shareholders of record as of Aug. 25, 2004. Moreover, Microsoft announced a one-time US$3-per-share dividend (a payout of more than US$30 billion in total) payable on Dec. 2, 2004, for shareholders of record as of Nov. 17, 2004. This special dividend has received a great deal of media attention, including stories about the tax effect of holding Microsoft common shares. In addition to considering the investment implications of these dividends, a hedge fund should understand how its partners might be affected by the so-called extraordinary dividend rules.
Qualified Dividend Rules
Before we focus on the special tax rules applied to extraordinary dividends, it’s useful to briefly review the beneficial qualified dividend rules. Since Jan. 1, 2003, qualified dividends received by an individual shareholder from domestic corporations and “qualified foreign corporations” have been taxed at the same rates as net capital gains (i.e., the excess of net long-term capital gains over net short-term capital losses) for purposes of applying both the regular and alternative minimum tax. Although they are taxed at the capital gains rates, qualified dividends do not absorb unutilized capital losses.
An individual shareholder must hold a share of stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date (more than 90 days during the 181-day period beginning 90 days before the ex-dividend date, in the case of certain preferred stock) for the dividend to qualify for the preferential tax rate. A mark-to-market election as a trader for U.S. tax purposes will not influence the holding period for qualified dividend purposes, and investors in these funds can achieve tax savings, as well.
Extraordinary Dividend Rules and Implications
For individual taxpayers, the basic effect of the “extraordinary dividend” rules would be
to convert any loss on a subsequent sale of the stock to a long-term capital loss to the extent of the dividend. Conversion of losses to long-term capital losses by a fund would flow through to the individual investor. This loss conversion effectively would negate some or all of the tax benefit achieved by receiving qualified dividends if the flowed-through losses offset the investor’s long-term capital gains.
Generally, a dividend on common stock is considered an extraordinary dividend if the amount of the dividend is equal to or greater than 10% of the shareholder’s adjusted tax basis in the common stock. For preferred stock, the threshold amount is reduced to 5% of the shareholder’s adjusted tax basis in the preferred stock. Dividends with an ex-dividend date within the same 85-consecutive-day period are aggregated for purposes of the above test. An extraordinary dividend also will result if the aggregate amount of dividends in one year exceeds 20% of the taxpayer’s adjusted tax basis in its stock. Certain exceptions apply, including an exception for certain stock held longer than two years. A significant result of these rules is that the determination of whether a particular dividend is an extraordinary dividend may be unique to each taxpayer and, in fact, to each tax lot held by that taxpayer.
For purposes of the extraordinary dividend rules, funds receiving the special Microsoft dividend would need to aggregate the September and December dividends, if applicable, because the ex-dividend dates fall within the same 85-day period. Consequently, for funds receiving both dividends, the relevant tax basis of Microsoft shares for extraordinary dividend purposes is US$30.80 (the aggregated dividends of US$3.00 and US$.08 a share multiplied by 10). Shares in Microsoft have not traded above the price of US$30.80 a share in more than a year. As of the date of this alert, Microsoft has not yet announced the date of its next regular dividend. Accordingly, such dividend has not been factored into this example.
Funds should not automatically conclude that a tax benefit would be lost for individual partners of the fund as a result of the extraordinary dividend rules. Therefore, it still could be beneficial to meet the qualified dividend holding period rules in order to take advantage of the reduced tax rate. If a fund has a long-term holding period on its Microsoft shares with a tax basis below the amount that would trigger the extraordinary dividend rules, no additional conversion would result since the loss, if any, would already be characterized as long-term. Moreover, to the extent that the fund’s holding in Microsoft shares does not produce a tax loss after the one-time dividend, an overall tax benefit can result should the one-time dividend be held for the requisite holding period to count as a qualified dividend.
For example, if a fund purchased Microsoft during April 2004 at a price of US$25.70 and should Microsoft trade at or above US$25.70 after the one-time dividend and be sold at such a price, no tax loss would result upon the sale, and qualified dividends would effectively be subject to the reduced dividend tax rate, with no corresponding offset as a result of the extraordinary dividend rules. Additionally, to the extent that any tax loss is less than the extraordinary dividend, the amount of any conversion would be limited to the loss, and some residual benefit may remain. Even if a full conversion of the loss to long-term capital loss is required, certain partners might have only net short-term capital gains in a particular year. In that case, none of the tax benefit of the beneficial rates for qualified dividends may be lost for these individual investors.
At times, fund managers in offshore funds, including those operating in a master-feeder context, have traded out of a position prior to an ex-dividend date. In part, these trades contemplate saving the withholding tax cost on the dividend for the offshore fund, which generally would be 30% in most offshore fund domiciles. In a master-feeder context, a better tax rate on this one-time Microsoft dividend might place domestic individual investors in conflict with the interests of offshore investors. Fund managers will need to consider this issue as it applies to this one-time Microsoft dividend.
Funds using a mark-to-market method of accounting for tax purposes will need to consider the benefits to be achieved, if any, by the one-time Microsoft dividend, given the interaction of the varying rules.
Funds having a combination of corporate and individual partners will need to track different holding periods for these two different types of investors and benefits because the corporate Dividend Received Deduction (DRD) holding period rule remains in effect (46 days; 91 days for certain preferred shares). To the extent that a fund has corporate partners, additional reporting will be required with respect to extraordinary dividends. This additional reporting is necessitated by the dividend-received deduction rules, under which a corporate shareholder that receives an extraordinary dividend is required to reduce the basis of the stock for which it received the dividend by the nontaxed portion of the dividend. If the reduction in basis exceeds the basis in the stock with respect to which an extraordinary dividend is received, the excess is immediately taxed as gain on the sale or disposition of such stock.
Howard Leventhal is co-national director of Ernst & Young’s Asset Management Tax Practice and a partner in the firm’s Global Hedge Fund Practice based in the New York financial services office. Joseph Bianco is a tax senior manager in Ernst & Young’s Global Hedge Fund Practice based in the firm’s New York financial services office.
Contact Bob Keane with questions or comments at: .