When you have a short position in a stock that pays out dividend, will you have to pay the full amount of the dividend to whomever you borrowed the stock from or only what corresponds to the after-tax value of the dividend? When the stock goes ex-dividend, the stock will drop. But since most investors pay tax on dividends, the stock should not drop by the full amount of the dividend, but only what corresponds to the after-tax value of the dividend, which may differ among different investors. But if the stock price goes down by less than the full value of the dividend, short sellers will get screwed if they have to pay the full value of the dividend to whomever they borrowed the stock from. I assume the final recipient of the dividend is the trader/investor buying the stock from the short seller when the stock is sold short. Question 1: Do short sellers have to pay the full amount of the dividend to compensate whomever they borrowed the stock from, or do they only have to pay the after-tax value of the dividend? Question 2: Who is the final recipient of the dividend and who is liable for the tax?
1-Full amount of the dividend 2-It really is not relevant to you and not everyone has a taxable account. Each long get the dividend. And, no one is getting "screwed." Each long is entitled to get paid and no one is forcing your to short that stock.
Another point is the buyer of your short is not the recipient. When you short, you borrow the stock. Your paying the dividend to whoever you borrowed it from.
As Robert pointed out, the fact is that the stock does drop the amount of the dividends. Why? As Robert mentioned, not everyone in the market is in a taxable account, for example the top 5 university endowments are over $100B combined, those are tax free accounts. But even for those paying tax, the long term (and short term for that matter) capital gains rate is the same as the dividend rate. So when a stock goes ex-dividend for a $1 dividend, the stock goes down by $1.00 and the owner has a $1.00 loss which exactly offsets the $1.00 dividend for tax purposes. If it didn't, one could arb that all day long or even set up companies who's main purpose was to provide such an arb. Like any risk free arb, it wouldn't last long!
Thank you for the answers. Your arguments make sense. In Europe there is an ongoing investigation in some countries, because the dividend tax rate differs a lot in different countries. It seems some banks systematically lent out shares on the record date to investors in countries with significantly lower dividend tax rates. Maybe it works like this: 1) The original investor in the high tax jurisdiction is compensated by the full amount of the dividend from the short seller, but does not pay tax, because the investor does not receive the dividend from the underlying stock. 2) The short seller does not receive the dividend but is liable to compensate the original investor the full amount of the dividend. The short seller will not pay tax on the dividend, because the short seller will not receive the dividend from the underlying stock. 3) The short seller will sell the stock short to a third investor. This third investor will receive the dividend from the underlying stock and pay the (lower) tax. But if this is the way it works in Europe, it must work differently in the US, because from my activity statements trading US stocks I can see, that I - the short seller - pays the withholding tax.
Thanks for pointing out my U.S. centric mindset, hate it when I do that! Do you know which countries specifically this arbitrage is happening in? It sounds interesting and I'd like to do some research into it.