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.