The payment in lieu of dividends issue arises in conjunction with the short sale of stocks. Short selling is a trading strategy to sell shares a trader does not own, and buy them back at a lower price, thus profiting from a price decline. If those sold short shares pay a dividend, a payment in lieu will occur.
To short sell shares of stock, a trader must first borrow the shares from a broker. A broker will lend shares for short selling out of its own inventory or lend shares of customers holding the stock in their accounts. If a trader sells shares short and those shares pay a dividend, the trader is responsible for paying the dividend amount to the broker. The money the short seller pays is not the actual dividend but is a payment in lieu of dividend.
A margin account agreement allows the broker to lend shares from customer margin accounts with outstanding margin loans. A customer whose shares have been lent will not know the actual shares are lent out. However, if those shares earn a dividend, the customer will receive the payment in lieu of dividend. The broker will notify the customer this has occurred.
Earned dividends may qualify for a lower income tax rate. The maximum tax rate on qualified dividends is 15 percent, compared to a maximum income tax rate of 35 percent. If an investor receives a payment in lieu of dividend for qualified dividends, that payment is not tax qualified and the investor must pay the higher regular income tax rate on the amount. The broker will issue a Form 1099-MISC listing the payment in lieu of dividends to the investor.
Brokers do not want to have customers receive payments in lieu of the regular dividend from stocks. With dividend-paying stocks, a broker may refuse to lend customer shares on the day a dividend will be paid, and may recall shares that will pay a dividend from short sellers. The broker has a right to force a short seller to buy back sold borrowed shares. Some brokers will pay a credit to an investor's account who received a payment in lieu to make up the difference for paying a higher tax rate.