This is now the season when companies distribute dividends to shareholders. Dividends on shares and income distribution on units is exempt from income-tax. An investor may seek to take advantage of such tax-exempt income by buying shares or units-cum-dividend just before they are quoted ex-dividend (the last date on which a purchaser will be entitled to the dividends) and selling them soon thereafter on an ex-dividend basis.
Normally, if there is no other major movement in the share or unit price, the difference in price on a cum-dividend basis and on an ex-dividend basis would approximate the dividend or income that has been declared. In effect, the loss that you make on the sale of the shares or units is matched by the dividend or income that you receive. Such transactions are known as dividend stripping transactions.
Can you obtain a tax advantage by setting off the loss that you incur against other capital gains, while the dividend or income on units is exempt from tax? Earlier, you could do so. In fact, even the Supreme Court upheld the allowability of such loss in cases of dividend stripping. This loophole has, however, been plugged since 2001 by an amendment to the law.
The law now provides that if you buy any securities or units within three months before the record date for dividend/income distribution and sell the securities within three months after the record date (in case of units, nine months after the record date), receiving exempt income in the form of dividends or income distribution on units, any loss that you make on the sale of such securities or units, to the extent of the exempt income that you receive, is to be ignored.
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Here’s an example. Suppose the record date for dividend distribution by a company is 27 August and the dividend amount is Rs35 per share. If you buy or have bought the company’s shares any time on or after 28 May and sell the shares at a loss on or before 26 November, the loss that you make will not be allowed to the extent of Rs35 per share, or the dividend that you have received on the shares. If you have incurred a loss of Rs75 per share, you will be allowed a loss of only Rs40, while if the loss incurred by you is Rs25 per share, the entire loss will be ignored. In any case, the exemption for the dividend will remain unchanged. But, if you have bought the shares before 28 May, or if you sell the shares after 26 November, the capital loss that you make will be allowed to you for tax purposes and can be set off against other capital gains.
Interestingly, this anti-dividend-stripping provision applies not only to capital losses but also to business losses. Therefore, even if you are a trader in shares, the tax benefit of the business loss that you may incur on sale of such shares would not be available to you.
The problem is more complex in the case of units—particularly in the case of schemes that declare income distribution on a regular basis—as the holding period required, so that the anti-dividend-stripping provision does not apply, is nine months after the record date.
When there are multiple record dates and multiple income distributions, how does one apply the provisions?
Let us take a situation where you have bought units of mutual funds for Rs25 per unit on 10 July 2010, the scheme has distributed income of Rs1.50 per unit on 30 September 2010, 31 December 2010 and 31 March 2011. If you sold the units for Rs20 per unit on 15 April 2011, to what extent would the loss of Rs5 per unit be allowable? The applicability of the pre-record date period for purchases and the post-record date period for sales has to be seen with reference to each record date. Only in the case of the record date of 30 September 2010, is the purchase within a period of three months prior to the record date. The sale date is also within nine months subsequent to the record date of 30 September 2010. With reference to the record dates of 31 December 2010 and 31 March 2011, the purchase is more than three months prior to the record dates and therefore the anti-dividend stripping provisions do not apply to such record dates. Therefore, out of the total loss of Rs5 per unit, only Rs1.50 per unit (being the income distribution on 30 September 2010) is to be ignored, and the balance loss of Rs3.50 per unit would be allowable.
Therefore, whenever you are selling securities or units at a loss within one year and are banking on the availability of such loss to reduce your capital gains tax liability, you necessarily need to take into account any dividends or income distributions that you may have received in the interim, which will reduce your taxable losses, though you may actually incur the loss.
Illustration by Shyamal Banerjee/Mint
Gautam Nayak is a chartered accountant.
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