Dividend and Bonus stripping - some issues.

[C.A. DEV KUMAR KOTHARI]

Summary : The press can seek credit for  early amendments in the Income Tax Act regarding dividend stripping and  bonus stripping. Amendments had taken place to lengthen the period of holding of mutual funds units if one wants full benefit of tax free dividend. For bonus stripping, it appears that restrictions  are in respect of  Units of Mutual Funds and not in respect of bonus stripping in case of shares of companies.

So far dividend is concerned , based on history of relevant provisions it can be said that the dividend received by the shareholder is not exempt but it is received after non creditable TDS. Rather the scheme of 'final tax' on distribution point has made all dividends taxable. In fact earlier a large portion of dividend was received tax free due to various deductions, but now all dividends bear compulsory tax - without any possibility of credit or claim for the same. Therefore, in such circumstances, when income tax is already collected,  resultant loss on sale of shares should not be considered as a case of dividend stripping as a measure of tax planning.

Provisions to curb avoidance of tax by certain transactions in securities :

Section 94 contains provisions in this regard. In relation to dividend of companies and mutual funds and bonus issue of units of mutual funds relevant sub-sections are (7) and (8). These have also been amended from time to time, therefore care should be taken to consider the provision as was applicable in any year. The relevant provisions are reproduced below with highlights.

Avoidance of tax by certain transactions in securities.

[(7) 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.]

 [(8) Where—

(a) any person buys or acquires any units within a period of three months prior to the record date;

(b) such person is allotted additional units without any payment on the basis of holding of such units on such date;

(c) such person sells or transfers all or any of the units referred to in clause (a) within a period of nine months after such date, while continuing to hold all or any of the additional units referred to in clause (b),

then, the loss, if any, arising to him on account of such purchase and sale of all or any of such units shall be ignored for the purposes of computing his income chargeable to tax and notwithstanding anything contained in any other provision of this Act, the amount of loss so ignored shall be deemed to be the cost of purchase or acquisition of such additional units referred to in clause (b) as are held by him on the date of such sale or transfer.]

Explanation.—For the purposes of this section,—

(a) "interest" includes a dividend ;

 [(aa) "record date" means such date as may be fixed by—

(i) a company for the purposes of entitlement of the holder of the securities to receive dividend; or

(ii) a Mutual Fund or the Administrator of the specified undertaking or the specified company as referred to in the Explanation to clause (35) of section 10, for the purposes of entitlement of the holder of the units to receive income, or additional unit without any consideration, as the case may be;]

(b) "securities" includes stocks and shares ;

(c) securities shall be deemed to be similar if they entitle their holders to the same rights against the same persons as to capital and interest and the same remedies for the enforcement of those rights, notwithstanding any difference in the total nominal amounts of the respective securities or in the form in which they are held or in the manner in which they can be transferred;

 [(d) "unit" shall have the meaning assigned to it in clause (b) of the Explanation to section 115AB.]

Dividend stripping:

Due to exemption of dividend (so called but not really exempt as discussed later on) in hands of shareholders there has been practice in vogue to purchase shares and units on cum dividend basis and sell the same on ex-dividend basis. Thus the dividend earned is claimed as exempt and loss on sale of shares and units including interest on capital borrowed for purchasing share or units is claimed as business loss (or short term capital loss). To curb this practice sub-section (7) of section 94 of the Income Act, 1961, provides that if shares or units are purchased within prescribed period prior to record date and  are sold within  prescribed period  after such record date (date fixed for ascertaining entitlement of dividend), then loss suffered on sale of such units or shares, to the extent dividend is exempt, will not be allowable.

 The law in relation to dividend is similar for shares and units both.

Newspaper reports and amendments about dividend stripping and bonus stripping :

In respect of dividend stripping the news reports prompted early amendment by way of insertion of sub-section (7) in section 94 of the Act w.e.f. 01.04.2002 to disallow loss to the extent of exempted dividend. After announcement of liberal bonus issues by several companies (leading being Infosys and Wipro) there were news reports in papers for use of opportunity to buy cum -bonus and sell ex-bonus shares of these companies to book allowable short term capital loss that can be adjusted against any capital gains. There are also cases of bonus stripping for units of mutual funds, but in those cases extent of bonus issue and price fluctuation is not as wide as in the case of shares. However, even after amendment, the curb tightened is only in respect of  bonus units stripping.

In past new papers have been major sources for prompting early amendment of law. In absence of news reports, it has been experienced that amendment in law may not take place before the Supreme Court decides the matter in favour of public. The history shows that most of the amendment to curb scope of tax reduction (so called loop holes) has been affected after ruling of the Apex Court. However, news report on section 37 (allowability of protection money), section 43(3) - definition of plant - to exclude tea bushes, amendment of section 80HHC for tea industry etc. have been a very useful tool in affecting early amendment. A lesson for taxpayers and practioners is to avoid publicity in newspapers on such issues.

Off course an exception was earlier budget presented by the present Finance Minister Mr. P. Chidambaram. Hat's off to him , he has plugged several loopholes in his proposals which were pointed out in articles published in various magazines. For example in respect of Tax on distributed income u/s 115O and 115R, several loopholes , as pointed out in articles written by the author were rectified.

Amendments vide the Finance (No.2) Act 2004

Vide the Finance (No.2) Act  2004  sub- section (7) was amended and  sub-section (8) was inserted  in section 94 of the Income-tax Act, 1961. The effect of the proposal was that dividend stripping in respect of units of mutual funds has been made more stringent and new provision has been introduced to avoid leakage of revenue by way of bonus stripping in case of units of mutual funds.

The relevant explanation is reproduced below: -

Measure to curb creation of losses via dividend and bonus stripping.

The existing provisions of sub-section 7 of section 94 provide that where any person buys or acquires any unit or security within a period of three months prior to the record date fixed for declaration of dividend or income in respect of such unit or share, and sells or transfers the same within a period of three months after such record date, and the dividend or income received or receivable is exempt, then, the loss, if any, arising from such sale and purchase shall be ignored to the extent such loss does not exceed the amount of such income or dividend, in computation of income chargeable to tax, of such person.

 It has been noticed that the condition specified in sub-section (7) of section 94 requiring an investor to hold units for at least ninety days after the record date did not provide the desired effect. In order to provide further deterrence to tax-avoidance, it is necessary to provide for a longer period of holding of units after a record date.

 It is accordingly proposed to amend the said sub-section so as to provide that where any person buys or acquires any unit within a period of three months prior to the record date and sells or transfers the same within a period of nine months after such record date, and the dividend or income received or receivable is exempt, then, the loss, if any, arising from such sale and purchase shall be ignored to the extent such loss does not exceed the amount of such income or dividend in computation of the income, chargeable to tax, of such person.

 To prevent the practice of bonus stripping, it is proposed that the loss on sale of original units where bonus units have been issued, will be ignored and the amount of such loss shall be considered as the cost of purchase or acquisition of the bonus units.

These amendments will take effect from 1st April, 2005 and will, accordingly, apply in relation to assessment year 2005-2006 and subsequent years.

Dividend stripping of mutual fund units :

As per proposals, purchase of units three months before the recorded date in the units purchased and if sold within nine months after the record date in respect of dividend and bonus units allotted will be governed by the new provisions whereby loss to the extend of dividend earned will not be allowed and loss suffered on sale of original units shall not be allowed and un allowed loss will be deemed to be cost of bonus units.

In respect of shares of companies time limit of three months after record date continues and there is no change.

Bonus stripping curb is only on mutual Funds units :

Other securities are not affected- may be due to a drafting mistake:

 As per amendments the provision for bonus stripping is applicable only in respect of units of mutual funds.

 Securities other than units of mutual funds are  not affected by the amendment and they  continue to be governed by the existing provisions. Therefore shares purchased cum bonus can still result into allowable capital loss or business loss if original shares are sold and bonus shares are not sold. Therefore, the bonus issues made by several companies will not be effected. A person who has purchased shares on cum bonus basis of any company can sell the original shares and claim short term or long term capital loss or business loss as the case may be as the cost of original shares purchased (cum bonus) is more than the price fetched by selling the original shares after having received bonus shares.

It appears that the considering the purpose for the amendment, and in view of widely used device of buying cum bonus and selling ex bonus shares and booking loss the shares of companies should also have been covered by the new provisions. In case due to a drafting mistake the issue of bonus shares by companies have been left out the scope of section 94(8) a suitable amendment in the  section  is required.

Section 94(7) - pre condition is exemption of tax :

Sub-section seven and its clause 'C' which is relevant, reads as follows.

 Where  ……..

(c) the dividend or income on such securities or units received or receivable by such person is exempt.

The question, which arises, is whether, the dividend is really exempt. The obvious answer is 'NO' for the following reasons: -

a)  The company or the mutual fund pays dividend on the income distributed, then only there is exemption under section 10 in hands of share or unit holder,

b) In the case of company's dividend paid and tax paid thereon is not allowed as an expenditure.

c)  mere exemption in the hands of shareholders is irrelevant because tax has already been paid by the company or the mutual fund.

d) tax on distribution point is an important device adopted by the GOI for early and better collection.

Dividend is really not tax free therefore section 94(7) may not be applicable:

In this regard a question arises as to whether dividend received in respect of units or shares is really exempt from Income Tax. If we go by the history of the provisions of sections 115O and 115R and corresponding exemption under Section 10, we find that the dividend was exempted under section 10 only in those periods in which a tax was levied under section 115 O or 115R. For example, let us take the case of 115O - the dividend declared by companies was earlier covered by Section 115O as effected from 1 June 1997 and it remained governed by these sections upto 31 March 2002. During this period dividend declared by companies was subjected to tax on distributed profits and correspondingly the shareholders were allowed exemption under section 10(33). 

Thereafter section 115O was amended and dividend declared during the period 01.4.2002 to 31.3.2003 was not covered by Section 115O and there was no tax on income distributed by companies. Correspondingly for this period dividend received by shareholders was also not exempt under section 10 that is to say it was taxable in the hands of shareholders.

Again with effect from 1.4.2003 section 115O was made applicable to dividend distributed by companies on or after 01.04.2003 and correspondingly for Assessment Year 2004-05 on wards  the dividend has been made exempted under section 10(34) in the hands of the shareholders. This shows that dividend has never been tax-free.

Thus, the tax has either been paid or levied and made payable at the point of distribution by the company or distribution company and exempted in the hands of shareholders. If no tax is levied on distribution then the shareholders have been asked to include the dividend received in taxable income. In fact by imposing tax on distribution a large portion of dividend earned by share or unit holders have been taxed, which was earlier not taxable due to basic exemption, set off of losses, deduction under sections 80L or 80 M, exemption on income of certain institutions, government etc. Now tax has to be paid on all distribution of dividend irrespective of the fact whether the recipient has taxable income or not. 

Therefore, it can possibly be said that dividend has never been exempted from income tax and therefore section 94(7) may not be applicable and the disallowance of loss to the extent of dividend is not applicable if tax has been paid under section 115O or 115R.

 Therefore, it can be said that so far dividend is concerned the loss arising on sale of any share or unit within prescribed time from the record date may not attract the provision of disallowance of the loss as contemplated in Section 94(7) because dividend is not exempt.

Whether such complex provisions can be fully complied with?:

The provisions relating to shares and units are related to general public as well as large investors. Even small money savers can invest in shares and mutual funds. Therefore these provision apply even to small taxpayers. The provisions are quite complex and changing from time to time. For general taxpayer ( even for general tax-practioners) it is very difficult to expect knowledge and compliance on such complicated issues. Now-a-days about 95% of return of income are processed and assessed in a summary manner. In such circumstances, if a taxpayer , due to ignorance of himself as well as ignorance of his general tax-practioner, is unable to compute income properly, it will be difficult to detect the mistake. Thus in many cases the provisions may not be strictly complied with. Provisions which have neutralizing effect over a period of time, and which are difficult to be complied with and monitored in majority of cases, are not desirable to remain in the statute book. The provision which gives artificial meanings and are not easily understandable , which may not be easily complied with and monitored  not desirable. Such provisions should be omitted and income should be computed as per normal transactions so that over a period of time income is computed in a natural way.

Some important judgments on related issues:

Distribution of assets on liquidation - The scheme of section 2(22)(c) is incompatible with the scheme of section 94. The two provisions are intended to meet totally different situations. The former provision cannot be dovetailed into the latter - CIT v. Vadilal Lallubhai [1972] 86 ITR 2 (SC).

Applying this principal it can be said that when provision of deemed dividend are applied, question of application of S. 94 will not arise. Even otherwise, deemed dividend will not be subject to tax U/s 115O, therefore, question of dividend being exempt will not arise because the shareholder will have to pay tax. 

Meaning of 'avoidance of tax' - The words 'avoidance of tax' are not colourless words. They are strong and compelling words connoting a positive volition; a deliberate intention on the part of the assessee to avoid tax - CIT v. Sakarlal Balabhai [2008 -TMI - 7120 - GUJARAT High Court].

Transaction must be mala fide - The transaction in order to attract section 94 must be mala fide or, in other words, must be a concerted action directed to the end of avoidance of liability for tax. There must thus be some device on the part of the assessee to avoid payment of tax on his real and true income - CIT v. Jai Narain Ram Chander 1980 -TMI - 36295 - (CALCUTTA High Court).

Transfer of shares prior to declaration of dividend - When an assessee transfers shares to his wife and children just prior to declaration of dividends, section 94(2) would no doubt apply to the transaction, but the assessee would be entitled to the benefit of section 94(3)(b) on the ground that the avoidance was exceptional and not systematic - Gurdial Singh Uppal v. CIT [2008 -TMI - 8390 - PUNJAB AND HARYANA High Court].

Meaning of 'exceptional and not systematic' - The juxtaposition of the words 'exceptional and not systematic' occurring in section 94(3)(b) shows that the Legislature was using the word 'systematic' in contradistinction to 'exceptional'. The avoidance of tax must be exceptional, that is, by way of exception to the normal practice of the assessee and it should not be systematic, that is, part of a regular reprehensible practice carried on by the assessee. Where there has been no systematic effort by the assessee to avoid the tax and it has been done only once, the provisions of sub-sections (1) and (2) are not attracted. The submission that a singular transaction if planned or designed or contrived can earn the status of 'exceptional' and 'systematic' is not impressive - CIT v. Vallabh Leasing and Finance Co. (P.) Ltd. [2008 -TMI - 11389 - MADHYA PRADESH High Court].

In view of these ruling also, presumption of legislature that every purchase and sale of securities in some circumstances is designed to avoid tax is not just and proper. In any case tax is imposed year after year. Over a period of time the tax advantage  availed in one year will be offset by tax disadvantage in future. Therefore considering medium term to long term ( three to five years period) any such provisions are not necessary and desirable.