(Un)Qualified: The Dirty Little Secret of (Some) ETF Dividends

August 25, 2005

ETFs have a reputation for tax efficiency. But where dividends are concerned, that reputation can be misleading.


The 2003 tax cut put the thrill back in high-yield investing.  By reducing the top tax rate on corporate payouts from 38.6 percent to 15 percent, the new law instantly made dividend paying stocks more attractive.  All of a sudden, a $1 dividend was worth 85 cents in the pocket of a rich[1] investor, instead of just 61.4 cents. 

Investors responded by buying up high-yield utility companies like they were the next Microsoft, and by piling money into any mutual fund with the words "dividend" and "income" in its name.  One exchange-traded fund (ETF) in particular - the iShares Dow Jones Select Dividend Fund (DVY) - stood in the middle of all the excitement.  Composed of 50 (and later 100) of the highest-yielding stocks on the market, DVY became a focal point for dividend-hungry investors, attracting more than $7 billion in the 18-months following its December 2003 launch.

When tax time rolled around in April 2005, however, DVY investors came in for a rude shock: Of the $1.91 in dividends paid out per share in 2004, only $1.63 enjoyed the low 15 percent tax rate.  The remaining 27 cents were subject to the old, marginal tax rate.  For a high net worth investor, that effectively slashed 5.5 cents per share off of the after-tax payout.

The problem was that the 2003 dividend tax cut came with a catch.  Or should we say, a qualification.  According to the law, dividends must be "qualified" in order to receive favorable tax status.  And 27 cents of the $1.91/share DVY dividend didn't qualify.

DVY wasn't alone. Across the ETF universe, and particularly in funds managed by Barclays Global Investors (BGI), a small but significant portion of their 2004 payouts failed to qualify for the new (lower) tax rate. 

The topic has received little coverage in the press, perhaps due to the relatively small numbers involved - what's a few cents here or there?  But in today's competitive era, where fund companies wage PR wars over single basis point differences in expense ratios, a ten or fifteen basis point reduction in after-tax return can make a real difference.

What Is A Qualified Dividend?

Before looking at how different funds faired on the dividend front - and why they faired differently - one must first understand how the 2003 dividend tax cut works.

In an effort to re-invigorate the economy and encourage companies to pay out more in dividends, the 2003 tax law slashed the top tax rate on corporate payouts from 38.6 percent to just 15 percent.  In order to "qualify" for this new tax break, however, dividends need to meet three criteria:

  1. They must be paid by an American company or a "qualified" foreign corporation.  A "qualified" foreign corporation is one that is either listed on an American stock market or based in a tax-favored country (think Mexico);
  2. They must NOT be paid by a REIT[2] or be interest-based - bond and banking interest payouts need not apply; and
  3. The company paying the dividend must be held in the shareholder's securities accout for 61 of the 120 days surrounding the dividend date. 

The last qualification is the one that gets ETF investors in trouble, because the 61-day holding period applies to both the shareholder and the fund itself. It's not enough for the individual shareholder to hold the mutual fund for 61 days surrounding the fund's dividend date; the fund itself must hold the company paying the dividend for the requisite 61 days as well.

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