Bonus and dividend stripping are sophisticated strategies investors employ to mitigate their tax liabilities. These tactics exploit the timing of dividends and bonus shares to engineer artificial losses used to offset taxable income. To counteract such practices and promote a fair tax system, India has implemented stringent regulations under Sections 94(7) and 94(8) of the Income Tax Act, 1961. These provisions disallow certain losses arising from these activities, ensuring a more transparent and equitable tax environment. This article delves into the intricacies of these rules, their broader implications, and their impact on taxpayers.
Dividend Stripping
Dividend stripping involves purchasing shares of a company shortly before a dividend is declared and selling the shares immediately after receiving the dividend. This sequence typically results in a drop in the share price equivalent to the dividend amount. While the investor benefits from a tax-free dividend, the sale of the shares at a reduced price generates a capital loss. This loss can be offset against other capital gains, effectively lowering the investor’s overall tax burden.
Impact Of Budget 2020 on Dividend Stripping
Before the 2020 Budget, dividends were exempt from tax in the hands of recipients, with the Dividend Distribution Tax (DDT) being paid by the entity distributing the dividends.
However, the Budget 2020 brought a significant shift by abolishing the Dividend Distribution Tax. Consequently, dividends are now taxed directly in the hands of the recipients.
The strategy of dividend stripping and its tax implications was particularly relevant when dividends were tax-free for recipients. With the new tax regime, where dividends are taxable for the recipients, the relevance and effectiveness of dividend stripping as a tax-saving tool have significantly diminished under current tax laws.
Income Tax Implications
Dividend stripping is perceived as a practice that results in a loss of revenue for the government. To counteract this, Section 94(7) of the Income Tax Act was introduced, which specifically disallows capital losses arising from the sale of securities in certain conditions.
Under these provisions, the applicability of tax rules on dividend stripping hinges on meeting the following criteria:
- Purchase Period: The investor must acquire shares or units within three months before the record date for dividends.
- Sale Period: The investor must then sell the shares or units:
o For shares, within three months after the record date.
o For units, within nine months after the record date.
- Dividend Receipt: The investor must receive dividends from these securities or units.
When these conditions are met, any capital loss resulting from the sale of shares or units—up to the dividend income received—will be disregarded. This ensures that taxpayers cannot use these capital losses to offset other capital gains, thereby preserving the tax system’s integrity and preventing revenue loss.
Illustration
Ram purchased 1000 shares of XYZ Ltd on March 10, 2018, at a price of Rs.300. The company announced a dividend of Rs.40 per share on 30 April 2018. Ram receives a dividend of Rs. 40,000 on 30 April 2018. The price of XYZ Ltd fell to Rs.260 after 30 April 2018. Ram sold the shares on 5 June 2018 making a loss of Rs. 40,000. Discuss the tax treatment.
Solution:
Purchase Cost = Rs.3,00,000 (1,000 shares x Rs.300)
Dividend Received = Rs. 40,000 (1,000 shares x Rs.40)
Sale Proceeds = Rs.2,60,000 (1,000 shares x Rs.260)
Capital Loss = Rs. 40,000 (Rs.3,00,000 – Rs.2,60,000)
Ram enjoyed a total benefit of Rs. 80,000 (exempt dividend income of Rs. 40,000 and a capital loss of Rs. 40,000, which can be used to set off against other capital gains).
Thus, as per section 94(7), the capital loss to the extent of the dividend received is disallowed. Therefore, the Rs. 40,000 capital loss is ignored for tax purposes because it matches the dividend income received. Thus, Ram cannot use this loss to set off against other capital gains.
Bonus Stripping
Bonus stripping is a sophisticated investment technique where an investor purchases units of a mutual fund just before the issuance of bonus units and sells the original units post-receipt of the bonus. This results in a capital loss due to the drop in the price of the original units, while the investor retains the bonus units. By holding the bonus units for over a year, the investor benefits from a lower tax rate of 10% on long-term capital gains (LTCG) and simultaneously offsets the short-term capital loss from the original units against other capital gains.
Impact of Budget 2022 on Bonus Stripping
In the 2022 Budget session, the Finance Minister introduced a pivotal amendment to Section 94(8) to address tax evasion strategies involving bonus stripping.
Previously, the provisions were limited to mutual fund units. However, the 2022 amendment expanded the scope by replacing the term ‘units’ with ‘securities and units,’ thereby encompassing both shares and mutual fund units.
Income Tax Implications
To regulate bonus-stripping activities, Section 94(8) of the Income Tax Act outlines specific provisions:
- Purchase Period: The investor acquires shares or units within three months before the record date for the issuance of bonuses on such shares or units.
- Sale Period: The investor sells the original shares or units within nine months after the record date for the issuance of bonuses.
When these conditions are met, any loss from the sale of the original units or shares is disallowed from being set off against any other income. Instead, these losses are added to the acquisition cost of the bonus shares or units, ensuring a more robust and equitable tax framework.
This legislative amendment underscores the government’s commitment to closing tax loopholes and fostering a more transparent and efficient tax system. By broadening the definition to include all securities, the amended Section 94(8) ensures comprehensive coverage and mitigates avenues for tax avoidance through bonus stripping.
Illustration
A mutual fund is going to issue bonus units in the ratio of 1:1. Ram, an investor bought 1000 units of such mutual fund before the record date for bonus issue. The price on the date of acquisition was Rs. 1,000. On record date, Ram will receive one bonus unit for every unit held i.e.1000 units. After the bonus issue, the market value of the units declined to Rs.500. Ram sold the 1000 original units at Rs.500 which he purchased at Rs. 1,000.
After one year, Ram sold the bonus units. Discuss tax treatment.
Solution:
Purchase Cost = Rs.10,00,000 (1,000 units x Rs. 1,000)
Sale Proceeds = Rs.5,00,000 (1,000 units x Rs.500)
Capital Loss = Rs.5,00,000 (Rs.10,00,000 – Rs. 5,00,000)
As per the above facts, Ram can set off the short-term capital loss of Rs.5,00,000 made from the sale of original units against any other capital gains.
As per section 94(8), the capital loss of Rs.5,00,000 arising from the sale of original units cannot be set off against any other capital gains. Instead, the entire Rs. 5,00,000 will be considered as the cost of acquisition for the bonus shares that were sold in the next year.
Thus, Ram’s capital loss is disallowed, and the cost base of the bonus units is adjusted, preventing tax avoidance through bonus stripping.
The dividend and bonus stripping regulations under Sections 94(7) and 94(8) of the Income Tax Act, 1961, are designed to curb tax avoidance strategies that rely on creating artificial losses. By disallowing capital losses and adjusting the cost basis of securities and units, these provisions uphold the integrity and transparency of the tax system.
Investors must stay informed about these rules to ensure compliance and strategize their investments in a tax-efficient manner. Understanding and adhering to these regulations avoids penalties and promotes a more equitable fiscal environment, aligning personal investment strategies with the broader goal of a fair and transparent tax system.