Shorting Prefs: Part 2

I have recently received an eMail from an Assiduous Reader who, having read the post Shorting Prefs, writes in and says:

I read the “Shorting Prefs” discussion dated February 19th, 2009 under the archive for ‘Reader Initiated Comments’ in your PrefBlog. I find this subject very interesting as it appears to be a very low risk way of profiting from inefficiencies in the pricing of pref shares.

As an example, I recently found two issues of Royal Bank perpetual prefs with almost identical annual dividends, but one yielding 6.5% and the other 6.2%. A study of historic trading revealed the two issues often traded at the same yield in the past year or two. Subsequently, I bought the higher yielding pref and shorted the lower yielding pref. If and when the two prefs trade with the same yield, my maximum profit will be about 4.6% (=0.3/6.5) on one side of the trade on a before tax basis.

I have found shorting pref shares online to be extremely easy with TD Waterhouse. There appears to be no problem in selling any pref short. I have sold five different prefs short to date. The uptick rule does apply, so sometimes you have to wait a while for your order to be executed, but this is a minor problem. Also the short interest positions on pref shares are readily available from, which is free for the first 30 days. The short interest positions on most pref shares appear to be very low (less than 1% of the shares outstanding).

My question is on holding a short position through the ex-dividend date. I realize I will have to pay my broker (TD Waterhouse) for any dividends that are paid out on my short position. But, am I liable for the extra dividend tax credit on the short position as well? Don’t short positions create extra dividends over and above what the issuer is paying out? This means extra dividend tax credits will be created. Does the Canadian government get stuck with paying out extra dividend tax credits because of short selling? These are questions for which I cannot find any answers on the internet relating to Canada, although I did find some information relating to the U.S. In the U.S., it appears that the extra dividends paid out by short sellers may be ineligible for tax purposes, according to one website. Brokers could then assign these ineligible dividends to tax neutral accounts. I am sure a tax paying investor would be extremely upset if he found out his dividends were ineligible because his shares were sold short without his knowledge.

I would appreciate any insights you have on the topic of short selling and dividend
tax credits.

The tax question came up in the post BBD.PR.B / BBD.PR.D, where, to my chagrin, I was punished for stepping outside my specialty with respect to the application of tax laws.

All I’m willing to do with respect to the tax laws now is refer to Section 260(6) of the Income Tax Act:

(6) In computing a taxpayer’s income under Part I from a business or property
(a) where the taxpayer is not a registered securities dealer, no deduction shall be made in respect of an amount that, if paid, would be deemed by subsection 260(5) to have been received by another person as a taxable dividend; and

(b) where the taxpayer is a registered securities dealer, no deduction shall be made in respect of more than 2/3 of that amount.

However, with respect to the inefficiencies of the marketplace, I will agree that a long-only account can occasionally pick up a little extra yield by swapping between similar issues. An example of this was given in the post MAPF Performance: August 2008.

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