If you have a margin account with a debit balance, you may have securities in your account that are eligible to be lent out to a broker. If the shares are lent over a record date, (when dividends are paid), you are generally eligible to receive substitute payments to make up for any dividends you may have missed. The borrower who received dividends typically pays this cost, which is passed back to you by your broker/dealer.
Prior to 2003, both actual dividends and these substitute payments were taxed at the federal level as ordinary income. Lower federal rates for qualified dividend income were subsequently introduced, but they do not apply to substitute payments in lieu of dividends. Therefore, these substitute payments are still taxed as ordinary income (at federal rates as high as 35% for tax year 2012, increasing to 39.6% for tax year 2013).
If you receive a substitute payment in lieu of a qualified dividend, you may qualify for an annual credit adjustment. Most brokers, including Fidelity, provide such adjustments annually to help cover any additional federal tax burden.*
Who might be eligible for the credit
You may be eligible to receive the annual credit adjustment if:*
- You are a U.S. citizen or resident alien.
- You received the substitute payment in an account registered as individual, joint, trust, estate, or "pass-through" entity type (partnership, LLC, LLP, etc.).
- The account is open at the time credit adjustment is made.
- You would have been eligible to treat (and report to the IRS) the dividend paid on the security on loan as a qualified dividend, had the security not been on loan and had you received the dividend paid on that security rather than the substitute payment in lieu of the dividend. (You will generally satisfy this condition if the applicable security is from a domestic corporation or a qualified foreign corporation, and you would have held the security unhedged for the requisite holding period for qualified dividend treatment.)
When the credits are paid
Credits for substitute payments received during the calendar year will be paid in the first half of March of the following calendar year, or as soon thereafter as all reclassification information is made available. The account receiving the substitute payment, or an eligible successor account, must be open at the time that adjustments are scheduled to be made in order to receive the credit.
How Fidelity calculates the credits
The annual credit adjustment is intended to compensate for any additional federal taxes you might have to pay. Fidelity assumes that the substitute payment is taxable at the highest federal ordinary income tax rate of 35% for tax year 2012, and the missed qualified dividend is taxable at the highest federal qualified dividend tax rate of 15%. (For tax year 2013, the highest federal qualified dividend tax rate will increase to 20% and the highest ordinary income tax rate will increase to 39.6%.)
Since the credit itself is potentially taxable, Fidelity makes a further adjustment, bringing the amount to 30.77% of the substitute payment received (for 2012 payments).
Reporting the credits on your tax return
Fidelity reports substitute payments in lieu of dividends or interest on line 8 of Form 1099-MISC.
Fidelity reports the annual credits for substitute payments you received on line 3 of Form 1099-MISC, part of your account’s consolidated tax reporting statement. The credits should generally be reported as “Other income” on your federal income tax return. Consult your tax form instructions or advisor for more information.