What it means
In securities lending, an investor lends shares to a borrower for a fee, often so that the borrower can sell them short (sell shares it does not own, hoping to buy them back cheaper). While the shares are on loan, the legal owner changes.
If the company pays a dividend during that time, the dividend goes to whoever now holds the shares, not to the lender. To make the lender whole, the borrower pays an amount equal to the dividend or interest.
That amount is the manufactured payment, sometimes called a substitute payment or payment in lieu. The lender's agreement with the borrower will say exactly when it is due and how it is calculated.
The amount is normally equal to the full gross dividend or interest, though adjustments can apply. The lender receives the same cash as if it had held the shares, but the character of the income for tax purposes may differ.
In many tax systems, a manufactured payment is not treated as a qualified dividend and may be taxed at a higher rate or lose certain credits. For that reason, institutions and individuals sometimes recall their loaned shares before a dividend date.
Others accept the tax difference in exchange for lending fees, or price it into the lending arrangement. Tax advisers should be consulted, as treatment differs between countries and over time.
Finance teams handling securities lending programmes need clear records of dividend dates, share counts and payments. Errors in the reconciliation can lead to underpayment, disputes with counterparties and incorrect tax reporting.
There is also a link to short selling costs. A short seller must fund every manufactured payment out of its own pocket, which is one reason that shorting a high-dividend share is more expensive than shorting a share that pays nothing.
In practice
Real-world examples.
Example
A pension fund lends 200,000 shares in a bank to a hedge fund. When the bank pays a dividend, the hedge fund passes an equal amount to the pension fund as a manufactured payment.
Example
A retail investor's broker lends her shares without her noticing. Her account statement shows a payment in lieu of dividend, and her accountant explains that the tax treatment differs from a normal dividend. She asks her broker to stop lending her shares in future.
Example
A fund manager recalls loaned shares two days before a dividend date because the tax cost of receiving a manufactured payment outweighs the lending fee. The shares come back, and the fund receives the real dividend. It resumes lending after the dividend date has passed.
Formula
Calculation
Manufactured payment = Dividend per share x Number of shares on loan
An investor lends 10,000 shares to a short seller. The company declares a dividend of $0.75 per share while the shares are on loan, so the manufactured payment is $0.75 x 10,000 = $7,500.
Suppose, for illustration, that a genuine qualified dividend would have been taxed at 15% and the manufactured payment is taxed at 30%. The tax on a real dividend would have been $7,500 x 0.15 = $1,125, while the tax on the manufactured payment is $7,500 x 0.30 = $2,250, so the investor pays an extra $1,125.Case study
Seen in the real world.
Alderbrook Asset Management is an illustrative, fictional fund that earns extra income by lending shares from its portfolio. It lent 500,000 shares of a utility company that paid a dividend of $0.40 per share.
The fund received a manufactured payment of $0.40 x 500,000 = $200,000. Its tax adviser pointed out that this income was taxed at a higher rate than the qualified dividend the fund would otherwise have received.
In this illustrative story, Alderbrook compared the extra tax cost with the lending fees earned, and decided to recall shares ahead of future dividend dates. The lesson was that securities lending income needs to be judged after tax, not before.
Watch out
Common mistakes.
- Assuming a manufactured payment is taxed in the same way as the dividend it replaces, when many tax systems treat it differently.
- Forgetting that the lender loses voting rights on loaned shares as well as the dividend.
- Failing to reconcile dividend dates with lending records, which can leave the lender short of a payment.
Questions
People also ask.
Who pays a manufactured payment?
The borrower of the securities pays it to the lender, to replace the dividend or interest that the lender missed. Most agreements make it due on the same day the company pays the real dividend.
Is it the same as a dividend?
Economically it is equivalent in cash terms, but legally and for tax it is usually a different kind of payment.
Why would a lender accept it?
The lender earns fees for lending the shares, and the manufactured payment keeps the cash flow whole.
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