Dividend Stripping Transaction

As per the text of Income Tax Act, 1961,

Section 94(7) says, 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.

In simple terms,

Dividend stripping refers to transacting in shares or securities linked to shares of a company on which dividend is payable. Typically, a dividend stripping transaction involves the following steps:

1. Purchase of securities/ units linked to shares of a company on which dividend is payable, at a price, say INR 100

2. Holding on the investment in the above securities/ securities linked to shares of a company and enjoying the benefit of dividend distributed on such investment, say INR 10.

3. Sale of the securities/ units linked to shares of a company at a lower price, say INR 85. This fall in price of the shares/ units linked to shares of a company is largely attributable to the dividend payout.

A dividend stripping transaction is particularly lucrative for a taxpayer since by virtue of section 10(33) of the ITA, dividend distributed by a company is not taxable in the hands of its shareholders. Further, the taxpayer may claim a carry forward or set off of the loss arising from selling the shares/ units linked to shares of a company at a lower price. Interestingly, section 94(7) of the ITA provides that only so much of loss is available for set-off or carry forward, which exceeds the amount of dividend earned on the shares/ units linked to shares of a company. In effect, in the above example the taxpayer would have incurred a loss of INR 15 by virtue of sale and purchase of the shares (100-85 = 15), however by virtue of section 94(7), only INR 5 (15 – 10 = 5) would be available as loss for set of and carry forward purposes.

In its recent ruling of CIT, Mumbai v. M/s Walfort Share and Stock Brokers Pvt. Ltd., the Supreme Court of India has held that losses arising from the purchase and transfer of units of a mutual fund, on which dividends have been freshly paid (also known as ‘dividend stripping’), are genuine.

The above analyzed ruling is noteworthy for two reasons. Firstly, the Supreme Court of India upheld the validity of dividend stripping transactions, as permissible affair under tax laws. Secondly, this ruling is yet another recognition of the distinction between tax avoidance and tax planning. The Supreme Court has reiterated that tax planning is perfectly valid, since it is within the four corners of law.

It is important to note that the Indian government is planning to introduce the Direct Tax Code (“DTC”) from April 2012. The DTC proposes to introduce a General Anti Avoidance Rule (“GAAR”), which could empower tax authorities to re-characterize a transaction entered into by a taxpayer and the income there from. The GAAR provisions are proposed to override the other provisions of the DTC. Currently tax planning is considered as legal. However, it remains to be seen how GAAR would impact tax planning by taxpayers, including in cases of dividend stripping.