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Dividend stripping help HNIs avoid cap gains tax
September, 25th 2008

Though not many investors have made huge short-term profits on their equity investments, there is a rush among high net worth investors to set off their gains against managed losses arising in mutual fund portfolios.

According to sources, a handful of equity funds one of which is an index fund are planning to allow cash-rich investors to book notional losses and set it off against gains made over the short term, in their bid to evade the 33.4% short-term capital gains tax.

Termed dividend stripping in mutual fund parlance, the small amount of capital loss (considering the huge losses investors have suffered in their equity portfolios) on fund portfolios will help HNIs salvage short-term profits made by selling equities in March and April, experts say.

Fund houses are blatantly allowing HNIs to set off their short-term losses. Dividend stripping is not forbidden, but at the end of it all, its the long-term retail investor who has to share his portion of dividend with opportunistic investors, said a fund manager of a leading fund house.

Dividend stripping refers to a method of avoiding tax by buying securities or mutual fund units before the record date and selling them after the record date. By buying the securities the investor will get dividends and by selling it, a short-term capital loss which can be set off against a short term capital gain and thereby reducing his tax liability.

The modus operandi is simple. ABC Mutual Fund has declared 60% dividend on its index scheme. Abiding by the Finance Ministry rule, the fund house sets the record date seven days prior to the date of dividend declaration. The rule states that investors who enters that particular scheme three months before the record date, can avail themselves of the payout. The fund house, for the benefit of its privileged investors (mainly HNIs), discreetly lets out their intention to pay dividend four months before the date of dividend declaration.

On getting the information, HNI investors are encouraged to invest more money into the scheme (fresh investments to end before the three-month period dividend consideration period begins). On the date of dividend declaration, the NAV of the fund will witness a fall.

The investors exits the scheme at lower NAV, immediately after pocketing the dividend. This will help them record a short-term capital loss. The capital loss will be to the extent of the difference between the NAV when he entered the scheme (before dividend declaration) and when he exits the scheme later. In the case of index funds, the investor will buy the fund and short the index so that he doesnt gain or lose further in the event of market moving either ways.

On paper, the investor has suffered a loss in capital; but if one looks closer, he has collected 60% dividend (which is tax-free) and also gets a chance to set off capital gains on investments like shares or real estate against the loss incurred on his mutual fund portfolio. Fund houses, on the other hand, are able to expand their AUM before the pay-out and also earn a sizeable AMC fee on the increased base.

There is nothing to stop dividend stripping within current regulations. It is a regulatory loophole to efficient tax planning. Trading dividend information prior to record date is illegal; that works something like insider trading in stocks. Such loopholes should be plugged by the regulator, said Crisil Fund Services head Krishnan Sitaraman.

Prabhudas Lilladher financial services CEO V Ramesh said: Though investors are not negatively impacted, it is not really good for the scheme to have rapid rise or dip in AUMs, considering the impact it will have on cash position with the fund manager. Long-term investors will have to share their portion of dividends with new entrants who are there just for tax arbitrage, Mr Ramesh said.

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