The method of dividend stripping used to be applied extensively to save tax on short-term gains. This practice involved, buying MF units on or just prior to the record date for declaration of dividend, pocketing the tax-free dividend amount and selling the units at the ex-dividend NAV thereby incurring a notional short-term capital loss. This (notional) capital loss could be used to set off other capital gain on which tax would otherwise have been payable.
The following example illustrates the point:
Number of units purchased 1,000
NAV at purchase on 1.6.16 Rs 28
Dividend per unit declared on 10.6.16 Rs 4
NAV at sale on 15.6.16 Rs 24
Purchase cost (1,000 x Rs 28) Rs 28,000
Dividend earned (1,000 x ` 4) Rs 4,000
Sale value (` 24 x 1,000) Rs 24,000
Short-term capital loss Rs 4,000
The net cash flow is nil (= 28,000 – 24000 – 4000). All that the investor has earned is the short-term capital loss of ` 4,000 and this loss can be used to set off capital gain earned in some other non-related transaction or carried forward for set off in subsequent years for 8 years.
Note that actually, in monetary terms, the investor has not incurred any loss. The loss is notional in nature, yet it can be used to set off actual capital gain.
Enter Sec. 94(7)
The exchequer realised that this practice is resulting in loss to the revenue and plugged it by introducing Sec. 94(7). Accordingly, for such transactions, the following conditions should be cumulatively satisfied for shares as well as MF units ––
- Purchase is within 3 months before the record date for dividend.
- For shares, after the record date for dividend, sale is within 3 months. For units, sale is within and 9 months after the record date for dividend or bonus.
- Dividend is tax-free, and
- If this transaction results in capital loss, then the loss to the extent of the dividend or income received or receivable on such securities or units, shall be ignored while computing income chargeable to tax.
In short, such loss cannot henceforth be used at all either for set off or for carry forward; it is wholly redundant. In terms of our example, the loss of Rs 4,000 has to be ignored and hence unavailable for setoff or carry forward.
Looking at it from the reverse angle, let us take another example to understand under what situation Sec. 94(7) is not applicable. Let us assume that you have purchased the units at NAV of ` 10 and the record date of the dividend was 1.5.16, the amount of dividend being 1% or ` 0.10 tax-free.
Sec. 94(7) does not become operative in all the following cases —
Case-1 : Date of purchase was before 1.2.16.
Case-2 : Even if the date of purchase was within 3 months of 1.5.16, the date of sale is after 1.8.16.
Case-3 : Irrespective of the dates of purchase and sale, the sale price is more than the purchase price. Since Sec. 94(7) specifically disallows losses, if there is a profit, albeit marginal, any fall in the NAV to the extent of the dividend is to be wholly ignored. In such cases, investors can continue to have their cake and eat it too, i.e. benefit from the fall in the NAV due to dividend payout and thereby paying the consequential lower tax.
Case-4 : Dividend was not tax-free.
Sec. 94(7) sinks teeth into the assessee only when the NAV at redemption in the Case-3 above is below Rs 10.
For instance, if —
(a) The NAV was Rs 9.98, the loss of Rs 0.02 will be disallowed.
(b) If the NAV was Rs 9.85, out of the total loss of Rs 0.15, Rs 0.10 will be disallowed and only Rs 0.05 will be allowed as loss.
All this is so, whether the dividend payout is monthly, quarterly or even daily! The conditions of this section are to be applied to each and every dividend. It has to be examined whether each individual dividend declared satisfies the conditions of the section. The dividend reinvestment option suffers most.
Provisions Applicable in Spite of DDT
Some experts have argued that since the dividends received are subject to Dividend Distribution Tax, the condition that the income received be exempt for applicability of Sec. 94(7) is not being met.
While practically this is true, technically, it is the MF which pays the DDT and therefore, the income when it is received by the investors is indeed tax-free in their hands.
Very Harsh on MFs
- The post dividend period for shares is only 3 months against 9 months for units.
- In the case of units, the provision is also applicable to bonuses, but not for shares.
- There is no DDT in the case of shares.
The Finance Act 2014 (FA14) Amendments
FA14 has been very harsh to debt-based schemes of MFs and consequently hurt the investors (6.7 million folios) under their umbrella, very severely —
- The base on which DDT is applicable has been raised from ‘dividend received by the investors’ to ‘distributable profits before application of DDT’.
- The holding period for getting the status of long-term has been raised from 1 year to 3 years. This period continues to be 1 year for shares.
- In the case of tax on LTCG, the option available to investors of paying tax @10% without indexation, if it is lower than @ 20% with indexation, has been taken away only in the case of MFs and not shares.
And the MFs are supposed to be pass-through vehicles.
Apparently, this has been done to divert flow of funds from debt-based schemes to banking industry. The intention is indeed praiseworthy but the action should have been different. It has to be realised that banks and the MFs have, more or less, level-playing field in this arena. If funds flow more strongly towards MFs, it is because of their expertise in managing the investor’s money.
The banking industry is also endowed with equally talented and dedicated work force. The need of the day is to improve the efficacy of the banking industry, possibly by removing or mitigating the various shackles imposed upon them such as priority lending at discounted rates to market-determined rates, in spite of such loans are associated with high risks and consequential NPAs. Thanks to the existing legislation and the system of administrating justice, the banking industry is reeling under the weight of high NPAs and no one appeared to be bothered.
The main lesson that was taught in economics is that the gravitational force of demand and supply is so strong that any tinkering with it, even through the most powerful tax mechanism, may succeed in short-term but will be disastrous in long-term.
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