Dealing with Bonus and Dividend Stripping

The short term capital loss on sale of original shares can be set off against income from short-term as well as long term capital gain

Investors are eagerly awaiting the earnings release by corporates as the earnings season for the financial year ended March 2017 has already began. This period is also marked with final dividend distribution by many companies. Many companies and mutual funds would also be offering Bonus units. It’s vital for investors to know the tax implications of these two events and plan investment strategy accordingly.

Dividend Stripping is a strategy that refers to the buying of stocks/securities/ units within a period of 3 months before and selling it within 3 months (9 months in case of units) after the record date. Record date is fixed by the company/ mutual fund for the purposes of entitlement of the holder of the securities/units to receive dividend. Ex-date is a two days before the Record date since in India we operate on T+2 bases. Price of share decrease in value on the ex-date. Investors can take advantage of getting tax free income in the form of dividend by making investment in shares for a short term and also book short term capital loss by selling the shares after record date. To curb this tendency, Income Tax Act 1961 had introduced Sec. 94(7) from Assessment Year 2002-2003 of which many retail investors are not aware.

Section 94(7) of income tax act prescribes the following 3 conditions that should satisfy for application of dividend stripping 1. Shares/units are acquired within a period of 3 months prior to the record date of dividend 2. Shares are sold within a period of 3 month or units transferred within a period of 9 months after the dividend record date 3. The dividend income received on such securities/shares/units received or receivable is exempt from tax If all the above conditions are satisfied; Sec 94(7) will apply and the short term capital losses on the sale of shares is allowed to be setoff only if it exceeds the exempted dividend income.

Let’s understand provision of sec 94(7) with help of an example. Mr. XYZ purchases 1,000 shares of ABC Ltd. @ Rs 60 per share on April 15, 2016. ABC Ltd. declares dividend of Rs 5 per share; record date being May 30, 2016. Mr. XYZ sold all his shares in ABC Ltd. on August 2, 2016 for Rs 48 per share. He would receive Rs 5,000 as tax free income in the form of dividend. He has also incurred a short term capital loss of Rs 12,000 (Sales proceeds Rs 48,000 less cost of acquisition of shares Rs 60,000). However due to application of provisions of 94(7), the loss that can be set off is only Rs 7,000 (short term capital loss less dividend received).

In a similar fashion, Bonus stripping is brought under the ambit of tax by the provision of Sec 94(8) of Income Tax Act, 1961. This is applicable on Bonus units allotted by open as well as closed ended mutual funds. Bonus units means additional units allotted without any payment based on holding of original units. Generally the Net Asset Value of the mutual fund units would fall after record date of Bonus unit distribution. As per the provision, the loss, if any, arising to a person on account of purchase and sale of original units shall be ignored for the purpose of computing his income chargeable to tax if the following conditions are satisfied; 

1. An investor acquires the units within a period of 3 months prior to the record date 2. Bonus units are allotted on the basis of holding of original units on record date 3. The investor sells all or any of the original units within a period of 9 months after such record date 4. However, he continues to hold all (or any) of the bonus units. 

If the above conditions are satisfied then, the loss arising to the investor on sale of all or any of the original units shall be ignored or cannot be adjusted/setoff against any other capital gains for the purpose of computing his income chargeable to tax. However it is further provided that the amount of loss so ignored shall be deemed to be the cost of acquisition of bonus units as are held by the investor on the date of such transfer. The loss per unit of bonus units allotted is calculated to determine the cost of acquisition.

Investors should be aware about tax implication on both these counts. Even with application of sec. 94(7) if investor believes that a company has declared attractive dividend and that this exempt income would be higher than the loss incurred at the time of sale; it can be a good strategy to buy. Further it is worth knowing that sec. 94(8) applies only to bonus units issued by mutual funds. Till date this provision is not applicable to bonus shares issued by companies listed on the recognised stock exchange. Hence bonus stripping in shares of companies is still an option to reduce capital gains tax liability. The short term capital loss on sale of original shares can be set off against income from short-term as well as long term capital gain and if there is no capital gains during the financial year can be carried forward for next 8 years for being setoff.