Though the government in 2005 put an end to dividend stripping by enacting a law, disallowing the sale of mutual fund units within nine months if they were purchased three months prior to the dividend record date, the I-T department has been trying to recover taxes from several assessees, who exploited this loophole prior to the enactment of the new law and evaded tax.
Dividend stripping is a method of avoiding tax by buying securities or mutual fund units just before the record date and selling them soon after. By buying those instruments, the investor used to get dividends and by selling them at a lower ex-dividend price, s/he used to book a short-term capital loss. This loss used to be neutralized by the short-term capital gain, thereby reducing the tax liability.
The I-T department will file its appeal in the case against Mumbai-based Wallfort Shares & Stock Brokers, which has become a benchmark for some “dividend-stripping” transactions. One of the longest-heard financial cases, it will have a wider implication on tax claims of around Rs 2,000 crore (Rs 20 billion).
Giving a major blow to the I-T department in the case, the Bombay HC last year ruled that any loss arising out of purchase and subsequent sale of mutual fund units, soon after receiving dividend, could be allowed as an expense for deduction from taxable income.
Following the ruling, even other investors in similar cases did not pay tax, which ran into around Rs 2,000 crore.
For the assessment year 2001-02, Wallfort had purchased 4.55 billion units from Chola MF on March 23, 2000 at Rs 17.57 per unit, totaling Rs 8 crore (Rs 80 million). On the same day, Chola MF distributed a dividend of Rs 1.8 crore (Rs 18 million) at 40 per cent per unit.
On March 27, 2000, the assessee (Walfort) sold the units by way of redemption and Chola MF repurchased them at Rs 12.97 each and paid Rs 5.90 crore (Rs 59 million).
The assessee had also received Rs 2.3 crore (Rs 23 million) as an incentive for purchase and sale of such units. So, on an investment of Rs 8 crore (Rs 80 million), the assessee received Rs 7.96 crore or Rs 79.6 million (in the form of dividend income, incentive income and sale consideration).
At the same time, on the units sale, the broking firm made a loss of around Rs 2.1 crore or Rs 21 million (Rs 8 crore or Rs 80 million minus Rs 5.90 crore or Rs 59 million). Since the dividend income was exempt from tax under Section 10(33) of the I-T Act, the assessee claimed business loss of around Rs 2.1 crore (Rs 21 million) to be set off against other income.
However, the I-T department maintained that the loss was created through a pre-designed set of transactions to avoid paying tax and added it back to the trading income of the assessee.
While the department called such transactions as ‘coloured’ and losses arising out of it as ‘artificial’ to evade taxes, the HC in its ruling said that such transactions needed to be seen with reference to Section 94(7) that dealt with tax avoidance transactions.
The section provided that where the units were purchased and sold within a stipulated time, the income from such units was exempt. So, while computing losses of such persons, the losses to the extent of the income received should be ignored. Thus, losses in excess of the income should be allowed for deduction.
However, the I-T department has now sent a final proposal to the finance ministry to fight this case in the apex court and the appeal is likely to be registered early next month, said a source close to development.