1. What is a Manufactured Dividend?

When you lend shares over a dividend record date:

• Real dividend: Paid by the company to the holder on record i.e. the borrower.
• Manufactured dividend: Contractual payment made by borrower to lender equal to that dividend, under the GMSLA / GMRA / Stock Lending Agreement.

Legally it is NOT a dividend. It is a contractual compensation.

But tax law deems it to be equivalent in many regimes:

• UK: Schedule 23A ICTA 1988, now Part 17 Chapter 3 CTA 2010 and ITA 2007 s.581-582 + Income Tax (Manufactured Overseas Dividend) Regulations SI 1993/2004
• US: IRC 1058 substitute payments - called Payment in Lieu of Dividend
• India: SEBI SLB Master Circular + Income Tax Act s.94(8) on dividend stripping

Correct accounting is:

For Lender:
Dr Receivable - Manufactured Dividend
Cr Dividend Income (but classification matters for withholding)

For Borrower:
Dr Manufactured Dividend Expense
Cr Payable

Failure happens in 3 ways:

1. Treating it as real dividend and claiming dividend exemption / participation exemption / tax credit that you are not entitled to.
2. Not grossing up for withholding tax - UK MODs require deduction of tax before 2014, post-2014 simplified.
3. Creating an artificial deduction - paying a manufactured dividend and claiming it as annual payment / management expense with no commercial purpose.

2. Consequences of Incorrect Accounting

• Disallowance of deduction + interest + penalties 30-70% in UK, 100-300% in India
• Re-characterization as unlawful distribution under Companies Act 2006 Part 23 - if accounts incorrect
• Ordinary income treatment vs qualified dividend - US: substitute payments taxed at up to 37% instead of 0/15/20%

3. Key Case Laws

A. UK - The Core Jurisdiction

1. Andrew Chappell v HMRC [2013] UKFTT 098 (TC) / [2016] EWCA Civ 809
The leading manufactured dividend avoidance case. Taxpayer claimed £303,123 deduction for manufactured overseas dividends paid to Barsbury Ltd under a stock lending scheme, reducing income from £553k to £250k. Tribunal found:

scheme with no underlying commercial purpose whatever
Payment of 'manufactured overseas dividends' as defined by para 4(1) Sch 23A ICTA

Held: Ramsay principle applies. Transactions viewed realistically were not genuine transfers. Deduction denied. This established that circular stock lending with no risk cannot generate deductible annual payment. HMRC recorded this as 10th successive win protecting >£900m tax.

2. HMRC v First Nationwide [2011] UKUT 174 (TCC)
Whether dividends paid out of share premium of Blueborder Cayman Ltd were "dividends" and "overseas dividends" for manufactured payments legislation.
Held: Both First Preference and Second Preference Dividends were deemed dividends and overseas dividends under Schedule 23A ICTA and MOD Regulations 1993. Transactions did NOT constitute sale and repurchase under s.737A/730A ICTA. Therefore manufactured dividends were deductible as management expenses.

Principle: Substance over form, but classification of underlying overseas payment determines MOD treatment.

3. Nicholas Barnes v HMRC FTC/22/2011
Scheme using accrued income provisions s.710-714 ICTA, stock lending and TCGA 1992 s.263B, manufactured interest provisions. Tribunal struck down artificial creation of losses via manufactured interest/dividends.

4. Clavis Liberty 1 LP v HMRC [2016] UKFTT 253
Partnership claimed deduction for cost of dividend rights but excluded dividend payments from trading profits, creating artificial loss. Invoked s.730 ICTA to treat dividends as income of Dickens Ventures Ltd. Held to be avoidance - loss denied.

5. HMRC v Coal Staff Superannuation Scheme Trustees Ltd [2022] UKSC 10
Supreme Court on pre-2014 MOD rules. Upper Tribunal had held that manufactured dividend regime constituted a restriction on free movement of capital. Supreme Court reversed - held NOT contrary to EU law. Important for withholding tax failure: pre-2014 you had to deduct tax on MODs; failure to deduct led to liability.

B. US

Provident National Bank and Revenue Ruling 2003-7
Under IRC 1058, if securities loan doesn't meet requirements, transfer is treated as sale, and manufactured dividend loses qualified dividend status. IRS position: Payment in lieu is ordinary income.

J. P. Morgan - Stock Loan Fee Cases (2012-2015)
Failure to account for manufactured dividends as separate from stock loan fees led to disallowance of foreign tax credits.

C. India Context (since you are in Delhi)

Though no Supreme Court directly on SLB MODs, relevant:

• CIT vs Walfort Share & Stock Brokers 2010 326 ITR 1 (SC) - dividend stripping s.94(7) - loss disallowed where dividend received and shares sold at loss.
• SEBI SLB Regulations: Lender must show manufactured dividend as "other income", not dividend under 115-O exempt. Failure = penalty under s.271C for failure to deduct TDS.

4. How to Account Correctly - Checklist

For Lender (UK/US/India GAAP):

1. Do NOT book as dividend receivable from investee company on ex-date if shares are out on loan.
2. Book: Dr Manufactured Dividend Receivable from Borrower / Cr Other Income - Substitute Dividends
3. Track withholding: In UK post 1 Jan 2014: MODs are exempt from withholding unless part of avoidance. Pre-2014 required deduction under ITA07 s.922-925.
4. No dividend tax credit / participation exemption unless specific regime allows.

For Borrower:

1. Gross up if required. Keep real dividend received (taxable as trading income) separate.
2. Manufactured payment is deductible only if incurred in course of trade - s.812 CTA 2010 - not if scheme under s.596 ITA 2007.
3. Disclosure under IFRS 7 / Ind AS 107 for securities lending.

Common Audit Failure Point: Companies net off real dividend and manufactured dividend. This hides withholding obligation and triggers HMRC investigation under CFM74370 manual.