iStockPhoto
iStockPhoto

Mutual fund stripping: creating book losses of Rs8,500 crore

Some argue that till the time no rules are broken, stripping is a fair tax planning strategy that is available. That is really not the case

An investor was sitting in his Chennai office with a smug smile. He had recently concluded the sale of his stake in an electronics company to a private equity fund for over 500 crore. But his smug smile was due to something else. Out of the blue, he had received a call from a leading wealth management firm. The suave talking private banker at the other end of the line had succinctly explained to him how smart tax planning through a dividend strip could help him save a bulk of his tax liability. “Invest in a mutual fund scheme that will give a large dividend after three months. The dividend will create a notional book loss, get your money back after three months and your taxes disappear," the private banker had put in simple terms to him. To which the Chennai investor with wide eyes queried, “But isn’t a mutual fund for the long term, and how would we ever know which fund will declare a dividend after three months? Isn’t that illegal?" The private banker explained, “For a smart investor like you, we have all this information informally beforehand. That’s our cutting edge. And it’s not just one fund; I have this information for four mutual funds that are doing this in October itself—welcome to the world of mutual fund stripping." He finally invested 140 crore in this dividend strip opportunity to create an accounting book loss of 50 crore and save his taxes. (This is a true story and the situation narrated here is exactly as it happened.)

Earlier, it was bonus stripping. To stop this questionable practice, the Association of Mutual Funds of India (Amfi) had come out with a best practice circular in May 2015, discontinuing bonus plans altogether. This was with the intent of ring-fencing the mutual fund industry from creating a negative environment for itself by conjuring these questionable, though legal, structures for tax avoidance. When the first reports of bonus stripping in mutual funds appeared in Mint in August 2014, Samir Arora, founder and fund manager at Helios Capital Management Pte. Ltd, had tweeted, “hum nahin sudhrenge" (we will not change). And that is what some participants in the mutual fund industry believe.

In American baseball player Yogi Berra’s words: It is like déjà vu, all over again. Except this time it is dividend stripping. In October, four mutual funds were seen discreetly informing high net worth investors of upcoming large dividends in January 2016, which they could use for dividend stripping. Industry estimates suggest that in the past month, these funds have collected 3,000 crore under these schemes.

To assess the overall impact of stripping in mutual funds, we took data from April 2014 till date, i.e. a period of around 18 months (see graphic). A total of 25,545 crore was collected in these options, creating an accounting book loss of 8,467 crore ultimately resulting in tax foregone for the government exchequer. These collections represent 18% of the total net inflows in equity, arbitrage and balanced funds during this period. So, effectively, 1 of every 5 of net inflow by the mutual fund industry is by design short-term in nature and towards stripping. There were 24 such stripping opportunities in this period and were spread across 10 mutual funds—representing a fair share of both large and small fund houses.

The question that begs an answer is that at one end, the mutual fund industry wants to position itself for managing long-term assets, then why do the actions of at least some of the mutual funds contradict this objective?

Some argue that till the time no rules are broken, stripping is a fair tax planning strategy that is available. That is really not the case. Firstly, “informal" disclosure of the dividend three months in advance is clearly a violation. Secondly, regulations state that dividends can only be paid out of distributable surpluses, i.e., booked capital gains and dividends received. Clever accounting practices by mutual funds creating additional dividend options and proportionate percentage share of distributable surplus easily bypasses this guideline. Thirdly, regulations also provide that any new options created under the same scheme should start at a par net asset value (NAV) of 10. However, mutual funds create new options at NAVs of existing options to bypass this and create dividend stripping opportunities. Thus, stripping violations happen at multiple levels to out-smart the system and also deprive the government of tax revenue.

It is imperative that the mutual fund industry, before staking its claim on long-term assets, also demonstrate through its actions to investors, the regulator and the government, that it indeed is focused on the long term.

Manoj Nagpal is chief executive officer, Outlook Asia Capital, a consulting and wealth management company.

Close