Financial Daily from THE HINDU group of publications
Saturday, Jan 24, 2004
Markets - Mutual Funds
Dispose `ex' for `mutual' benefit
T. C. A. Ramanujam
Like dividends, incomes received from mutual funds are exempt from tax. Mutual funds have been declaring hefty dividends in the past six months. The exemption of dividends offers an opportunity for legitimate tax avoidance. One can buy a unit of a mutual fund before the record date, receive the tax-free income and transfer the unit ex-dividend. The purchase cost will be inclusive of the dividends and the sale will be exclusive of such dividend and, therefore, a short-term capital loss can be booked. This loss can be set of against short-term capital gains from purchase and sale of equities, thereby reducing the legitimate taxes payable. Finance Act, 2003 conferred tax exemption on income from units received by a unit holder from a mutual fund.
With respect to dividends, the practice of tax avoidance through dividend stripping transactions was sough to be counted through Section 94 of the Income-Tax Act, 1961. Section 94(3) however declares that it is open to the party to prove that the avoidance of tax was exceptional and not systematic. This clause was cited before the Madhya Pradesh High Court, in the CIT vs Vallab Leasing & Finance Co (265 ITR 1) case, to thwart an appeal by the Revenue in respect of assessment year 1994-95. In that case, the assessee had sold shares in the company a month before the declaration of dividend. Dismissing the Revenue's appeal, the MP High Court observed:
"There has been no systematic effort by the assessee to avoid the tax. It has been done only once. In the absence of any kind of regular transaction or recurring transaction, the provisions of sub-sections 1 and 2 of Section 94 are not attracted."
Finance Act, 2001, introduced sub-clause 7 in Section 94 to curb creation of short-term losses by certain transactions in units. The Memorandum explaining the provision had this to say:
"Under the existing provisions contained in Section 94, transactions of sale and purchase of securities which result in the interest or dividend in respect of such securities being received by a person not being the owner of the securities, are to be ignored and the interest or dividend from such securities is required to be include in the total income of the owner.
"It has been pointed out that the purchase and resale of the securities, including units of equity-oriented mutual funds, is being carried on for the purposes of creating short-term losses. These losses are set off against other income and thus an unintended benefit flows to the taxpayer. This practice, popularly known as dividend stripping, is being widely used to reduce the tax, which would have been otherwise payable, by the taxpayers.
"It is proposed to insert a new sub-section (7) in the said section to provide that where any person buys or acquires securities or unit within a period of three months prior to the record date fixed for declaration of dividend or distribution of income in respect of the securities or unit, 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 purchase or sale shall be ignored to the extent such loss does not exceed the amount of such dividend or income, in the computation of the income, chargeable to tax, of such person."
It will be interesting to note that the newly inserted sub-clause 7 does not provide for exemption on the basis of exceptional circumstances as in the case of sub-clause 3 of Section 94. It is necessary that the two provisions should be harmonised. The reference to the "exceptional" circumstance in sub-clause 3 should be removed. This has been taken advantage of in several cases, such as Sakarlal Balabhai (69 ITR 186), Gurdial Singh Uppal (85 ITR 238) and Vallab Leasing and Finance Co (265 ITR 1).
Again, Sections 70 and 74 provide for set off and carry forward of short-term capital gains and loss. Section 2(42A) defines a short-term capital asset in the case of a share or a unit of a mutual fund as an asset held by an assessee for not more than 12 months. Under these circumstances, the reference to a mere six months period, three months before and three months after the record date, in Section 94(7) is difficult to appreciate.
Last year's Budget granted exemption from capital gains tax in respect of shares purchased after April 1, 2003, on condition that they are held for 12 months. It is necessary that 12 months should be incorporated in Section 94(7) to prevent, among other things, avoidance through profit booking and sale of mutual fund units at a time when large dividends have been declared as in the current year.
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