Dividend & Bonus Stripping

Can you please explain the concept of tax planning by dividend stripping?

The dividend stripping is nothing but getting tax free income in the form of dividend and creating capital loss at the same time.The total effect of such device on your income is handsome saving of tax .The dividend is tax free whereas the capital loss incurred on sale of shares or units is utilised for reducing the profit under short term capital gains or income under any other head Let us take an example. XYZ mutual fund advertises for dividend on a particular fund as follows :

Amount of dividend : Rs 10 per unit

Price of Unit : Rs 30

Record date : 1/7/2001

If you purchased 1,00,000 units by 1/7/2001, the mutual fund, you will get following on 2/7/2001

Dividend from mutual fund company : Rs 10,00,000
Payment made for acquiring units : Rs 30,00,000
Price of units on 2/7/2003 (ex dividend) : Rs 19.50
Capital Loss on sale of units : (30 -19.50) x 1,00,000 = 11,50,000.
Net Loss to you : 30,00,000 -10,00,000 -11,50,000 = Rs 50,000

So, if you invested in units before record date i.e 1/7/2001 and sold after the record date , you received income in form of dividend of Rs 10,00,00 which is tax free and capital loss of Rs 11,50,000, both at the cost of small amount of money of Rs 50,000. Why will you do this?Because , you have in your accounts short term capital gains or other heads income which will be adjusted up to Rs 11,50,000. You will save paying tax of Rs 3,45,000( 30 % of 11,50,000 ) at the cost of Rs 50,000. How smart!

The dividend stripping was so much in vogue that the mutual fund industries and some companies made it an instrument to garner funds and giving people chance to do "creative tax planning' .Can you do it now? No, because the government has amended section 94(7) . The said section provides as under:

Sec. 94(7) Where

(a) any person buys or acquires any securities or unit within a period of three months prior to the record date;

(b) such person sells or transfers

(i) such securities within a period of three months after such date; or

(ii) such unit within a period of nine months after such date;

(c) the dividend or income on such securities or unit received or receivable by such person is exempt,

then, the loss, if any, arising to him on account of such purchase and sale of securities or unit, to the extent such loss does not exceed the amount of dividend or income received or receivable on such securities or unit, shall be ignored for the purposes of computing his income chargeable to tax.

The aforesaid provision states that the loss equal to dividend amount shall not be adjusted with any income while computing total taxable income if you purchase the said shares or units 3 months prior to record date for dividend and sell within 3 or 9 months from the record date respectively. Since the adjustment of loss was major attraction, the amended provision took away major incentive for such creative tax planning.

The Birth of the Great Bonus Game!

The government filled up one hole, the creative tax planner invented another way of tax planning. They started giving bonus , usually 1:1 , and people would sell the original units which will result in loss while the bonus units shall be kept for some time.For example , a mutual fund announces 1 :1 bonus and the price of units is Rs 30. Therefore, anyone who subscribe 1 lakh units before record date, shall get another lakh of units . The total outgo will be Rs 30 lakh. After the record date , the units NAV will be around Rs 15 . The subscriber sells 1 lakh of original units and computes loss of Rs 15 lakh (RS 30,00,000 - Rs 15,00,000) . This loss of Rs 15 laks is used to adjust the income under other heads. The bonus units having cost of zero is not sold in the year in which adjustment is done.This technique also became very famous among mutual fund industries and tax planners , therefore, government brought in sub-section 8 of section 94 from Fy 2004-05 (Asst Yr 2005-06 ) which states

94(8) Where

(a) any person buys or acquires any units within a period of three months prior to the record date;

(b) such person is allotted additional units without any payment on the basis of holding of such units on such date;

(c) such person sells or transfers all or any of the units referred to in clause (a) within a period of nine months after such date, while continuing to hold all or any of the additional units referred to in clause (b),

then, the loss, if any, arising to him on account of such purchase and sale of all or any of such units shall be ignored for the purposes of computing his income chargeable to tax and notwithstanding anything contained in any other provision of this Act, the amount of loss so ignored shall be deemed to be the cost of purchase or acquisition of such additional units referred to in clause (b) as are held by him on the date of such sale or transfer.