Tuesday, 15 April 2014

Dividend Stripping!!

What does dividend stripping mean? It refers to a practice of buying shares of a company or units of a mutual fund just before the record date for declaring a dividend, receiving the dividend and then selling the security/unit after the record date.

Normally, the investor would incur a short-term capital loss (because the ex-dividend sale price of

shares will be lower than the purchase price), which in the absence of certain provisions in the Indian Income Tax Act (as it exists today) could have been set off against a short-term capital gain (from some other capital asset) and thereby, reducing his tax liability. Every company, by law, maintains a register of members. Members whose names appear in this register as on a record date are eligible to get dividends.

However, the Finance Act, 2001, introduced sub section (7) to section 94 with effect from April 1, 2002, to counter such dividend-stripping activities.

Now, whenever a person sells shares or units and the following three conditions are simultaneously met, the short-term loss arising on sale — to the extent it does not exceed the exempt income — has to be ignored.

The conditions:

1 The purchase has been made within three months before the record date
2 The sale has been made within three months in case of shares and nine months in case of units, after the record date, and the dividend is tax free

Here is a scenario to illustrate this further.

Rakesh Mehta has short-term capital gains of Rs. 500 in a year. He has purchased 1,000 shares of “Able Ltd” for Rs. 10 each, aggregating to Rs. 10,000. He got a dividend of Rs. 300 and subsequently sold these shares within a period of three months after the record date.

A set-off of the short-term capital loss will not be possible due to application of the provisions of Section 94(7).

Here is why:

Let us assume that Rakesh sells the shares for Rs. 9,800. This loss of Rs. 200 shall be entirely ignored for tax purposes and not be available for set-off, as it does not exceed the exempt dividend income of Rs. 300.

Now let us suppose that Rakesh sells the shares for Rs. 9,600. There is a total loss (cost minus sale consideration) of Rs. 400. Now only Rs. 300 of such loss shall be ignored and Rs. 100 (to the extent that it exceeds the exempt dividend income of Rs. 300) shall be allowed as a set-off against short-term capital gains in the current year. Thus his taxable capital gains for the year shall be Rs. 400 (Rs 500 minus Rs. 100).

With share prices fluctuating so widely, the restrictive provisions of section 94(7) must be carefully noted.
Introduction of section 94(8) by the Finance Act, 2004, with effect from April 1, 2005, has countered bonus-stripping activities in respect of mutual fund units.

These restrictive provisions are applicable if the following conditions are met:

1. The purchase of units (original units) has been made within a period of three months prior to the record date
2. Such person is allotted additional units (bonus units) without any payment, on the basis of his holdings on the record date; and
3. Such person sells or transfers all (or any) of the original units within a period of nine months after the record date but continues to hold all (or any) of the bonus units

However, this is not the end of the analysis. In case, you do have a short-term capital loss during a particular year, it may be worthwhile exploring the possibility of selling the bonus units, earning a short-term capital gain and setting off the two. Subsequently, in the next financial year, the original units could be sold without attracting the provisions of section 94(8).

We have mentioned earlier, that bonus stripping has been dented, but please note the fine print, this applies to mutual funds units only.

Let us take another illustration. Instead of dividends, Rakesh Mehta is given bonus shares in the ratio of 5:1. In other words, against a holding of 1,000 shares, he is given 200 bonus shares. He sells the entire lot of 1,000 shares within three months of the record date for a price of Rs. 7 per share ( a loss of Rs. 3 per share) aggregating to Rs. 3,000.

Here, he will be able to set off the short-term capital loss against his capital gains of Rs. 500 for the year and carry forward the balance unabsorbed capital loss (Rs 3,000 minus 500) of Rs.2,500 to the next year. In fact, the unabsorbed portion can be carried forward to the next eight years.

The bonus share will be carried at zero cost and the entire net proceeds would be taxed when sold subsequently.

It may be worth noting that an investment made with a long-term view in mind, thoughtfully keeping at bay the narrow idea of tax savings as a consideration, is the best bet. However, if one has incurred short-term capital losses, the provisions relating to bonus and dividend stripping must be kept in mind while computing the final tax liability.

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