Anyone have specifics on how Bush's tax plan will affect day traders?

Discussion in 'Taxes and Accounting' started by EF4869, May 24, 2003.

  1. EF4869


  2. cant see much there for daytraders. it will help long term investors because of long term cap gains and dividend cuts .
  3. mskl


    from Barron's:

    Dividend Tax changes could change fair values whether or not one qualifies for preferential tax treatment:

    Taxing Bears: Short-sellers to pay more to borrow shares under new tax regime

    By Erin E. Arvedlund
    2,837 words
    26 May 2003

    Short sellers already pay a stiff price for their contrary views. But now they may have to pay even more. The tax-cut plan hammered out by Congressional conferees last week is causing a stir among short-sellers at mutual funds and hedge funds, since it turns out the tax package may make it more expensive for short-sellers to borrow stock and bet against companies they believe to be bad investments.

    Short sellers borrow shares they don't own and sell them in the market on a bet the stock will go down in price. Shorts buy back the borrowed shares at a profit if and when the stock drops.

    But the dividend-tax relief has thrown a wrench into that process. According to Lehman Brothers tax expert Robert Willens, shortsellers may have to cough up about $1.30 a share for every $1.00 in dividends paid out on shares they borrow.

    Say, for example, XYZ Co.'s stock dividend equals $1.00 a share. A short seller looking for a borrow would approach holders of the stock -- perhaps a mutual fund, or a big wirehouse on Wall Street that lends out stock. For the lenders to be "made whole," that is, to still wind up with $1.00 on an after-tax basis, they need a payment in lieu of dividends. That money would be paid by the short seller who's borrowed the shares.

    Under new tax law approved by Congress and being readied for President Bush's signature, the rate on dividends in the current tax package totals 15% -- the same rate as long-term capital gains. But not for dividends on borrowed shares; the rate is 35%.

    How does Willens arrive at the math? For the stock lender, who is foregoing $1.00 of dividends, the seller/borrower would have to pay $1.30 so the lender (using a 35% tax rate) would emerge with the same after-tax amount (85 cents) as if he or she kept the stock plus the dividend.

    "This is going to materially increase the cost of executing a short sale and, on the margin, could probably eliminate the short seller's expected profit from the trade," Willens say. The dividend exclusion "has an important collateral consequence for hedge funds and other short sellers."

    There are three parties in a short sale; the lender, the short seller/borrower, and the ultimate purchaser. The IRS ruled back in 1960, in Revenue Ruling 60-177, that the payment credited to the lender's account is not a "dividend" but an equivalent hypothetical amount. The dividend implies ownership of stock, but in a short sale, the purchaser (and not the lender, or the borrower/short seller) is considered the owner of the stock. With dividends taxed as ordinary income, as they are currently, there were no tax consequences to the distinction.

    If it becomes more expensive to short, will the whistleblowing by shorts dry up? "There will there be a smaller supply of securities available, which will mean the market is less efficient," says one hedge-fund partner. "If there's a premium, arbitrage strategies will become more expensive, and the markets less efficient."
  4. range


    from NY Times:

    May 27, 2003
    Circuitous Tax Changes for Traders

    HERE is an unwelcome surprise for short-term stock traders in the new tax law: They may have to pay full income-tax rates on some dividends they receive.

    The new law also contains bad news for short-sellers, with a provision that could make it more difficult, or at least more expensive, to borrow shares before selling them short. But that provision was effectively waived for this year.

    Approved by Congress last week, the law reduces the tax rate on most dividends to 15 percent for most taxpayers, although the rate will fall to 5 percent for low-income taxpayers, few of whom own dividend-paying stocks anyway. Under the previous law, such dividends were taxed at the same rates as ordinary income.

    For dividends, the law is retroactive to the beginning of this year, and as a result covers all dividends paid in 2003.

    The catch for short-term traders is that the law sets a minimum 60-day holding period for the investors to get the dividend break. So a trader who sells stock less than two months after buying it will have to pay taxes at ordinary tax rates on any dividends received while the stock was held.

    The new law reduces the top ordinary tax rate from 38.6 percent to 35 percent, so the result will be that traders who do not hold on to their shares for at least 60 days could pay tax at more than twice the capital-gains rate that otherwise would be charged.

    The 60-day provision was an increase from a 45-day provision in the version of the law the House passed, and drew some criticism.

    "I think this rule may be broader than necessary," said David P. Hariton, a tax partner with Sullivan & Cromwell, adding that the provision was aimed at stopping investors from using tactics that would produce fully excludable dividend income and approximately equal amounts of capital losses. Such losses could then be used to offset unrelated capital gains. "But with dividends and long-term capital gains taxed at the same rate, one only needs to be sure that such losses don't offset short-term capital gains," he added.

    The law is fairly expansive in terms of which dividends will qualify for the preferred rate. It will not matter — as it would have in the bill proposed by President Bush — whether a company has paid corporate income taxes. And dividends from foreign companies will be treated the same as those from American companies, if the foreign company comes from a country with a tax treaty with the United States or if the shares are traded on an American stock market.

    But dividends from certain kinds of American companies that escape tax at the corporate level — like real estate investment trusts and registered investment companies — will be fully taxable unless the company is passing on dividends it received from companies in which it invested.

    The provision of interest to short-sellers — and to investors whose shares are lent for shorting — specifies that payments in lieu of dividends are not entitled to the same favorable tax treatment as dividends. A payment in lieu of a dividend is made by a person who borrows stock and sells it short. The payment goes to the owner of the shares.

    Until now, the distinction between dividends and payments in lieu of dividends has not been an important one for individual taxpayers, since both were taxed at the same rate. But once the new law fully takes effect, an investor who receives a payment in lieu of dividends will pay a higher tax than one who gets dividend income.

    The Congressional conference committee report says it expects the Internal Revenue Service to not penalize brokerage firms that are unable to differentiate between the two kinds of payments this year. It also says the service should allow investors to treat payments reported as being dividends as dividends in 2003 "unless they know or have reason to know that the payments are in fact payments in lieu of dividends rather than actual dividends."

    The conferees instructed the Treasury Department to act quickly to issue guidance on payments in lieu of dividends.

    Many shares that are sold short are borrowed from margin accounts held by individual investors, usually without investors being aware of the specific loan. Presumably, brokers will have to keep track of that beginning next year. It is not clear whether investors will be able to keep their shares from being lent, although such loans could cost investors valuable tax benefits.

    Institutional investors often lend shares for a fee that enhances the profits of the institution. It is likely that such institutions will now change their behavior depending on the tax status of their owners. Pension funds, which pay no taxes, will likely wish to keep lending shares. But mutual funds that cater to individual investors, rather than 401(k) pension accounts, will probably not want to lend shares.

    The result could be a decline in the number of shares available for borrowing, which could make it harder to sell some stocks short. Alternatively, it could lead to an increase in the fees charged for borrowing some heavily shorted stocks.

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  5. nitro


  6. Trajan


    This is going to fuck up option pricing models.
  7. mskl



    You are correct. In fact, I have been saying this for months. Spreads will get wider in many deravative products. Options, SSF's and Index Futures where divs are an issue will all be affected if the tax laws stand as is. After speaking to several Exchanges, it is clear that they were not aware of this issue.

    One will have to use two different dividends when pricing deravatives. One, where you are short the div and one where you are long. The difference will be the "increased spread". This will be about 31% of the dividend.

    If the dividend taxes were eliminated then the difference would have been about 54% of the dividend.
  8. Trajan


    Confusion ought to bring opportunity then. When do we have to worry about this, now or beginning of next year? I don't have any positions with stocks paying dividends, so no rush for me. I had planned to work up my own model, or at least investigate other choices, over this summer for options anyways. A more complex model will only drive the business more and more into the quant arena.
  9. mskl


    at the beginning of next year. The "extra" short costs will not start until 2004.