The Hindu Business Line : Amendments that do not wash well

BOND washing and dividend stripping are sophisticated tax avoidance devices. You buy securities and shares cum-bonus and cum-dividend and sell them ex-bonus and ex-dividend.

Dividend is tax-free and bonus shares are not considered as income. The fall in the share value after bonus and dividend results in a capital loss in respect to the original shares, which can be set off against other capital gains.

Section 94 (7) of the Income-Tax Act, 1961 aims at preventing tax avoidance by a set of transactions in shares or units which are `self-cancelling'. An investor selling shares and securities ex-dividend at a lower price incurs short-term capital loss which is neutralised by the tax-free dividend. There is no loss in monetary terms.

To plug this loophole, the Finance Act, 2001, inserted sub-section (7) to provide that where any person buys or acquires any securities or units within three months prior to the record date, sells or transfers them within three months after such record date, the dividend or income received is exempt.

The loss, if any, arising out of such purchase and sale shall be ignored to the extent of such dividend or income.

The abuse of tax exemption provision for dividends by companies parking their surplus funds in mutual fund units for three months was taken note of by the Finance (No. 2) Act, 2004.

For amending Section 94, the Explanatory Memorandum points out that the conditions specified in Section 94(7) requiring an investor to hold units for at least 90 days after the record date did not have the desired effect. In order to provide further deterrence to tax avoidance it was found necessary to provide for a longer period of holding of units after the record date.

The amendment, therefore, lays down that where any person acquires any unit within three months prior to the record date and sells or transfers the same within nine months after such record date, then the loss, if any, arising from such sales 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. One important condition here is that the dividend or income received or receivable should be exempt from tax.

To prevent the practice of bonus stripping, it is now 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 take effect from assessment years 2005-06 onwards.

In respect of shares of companies the holding period continuous to be three months after the record date and there is no change.

It is only in respect of mutual fund units that the time limit is extended to nine months. This amendment will, therefore, not affect issue of bonus shares by companies such as Infosys and Wipro.

Those shareholders can still claim capital or business loss by bonus stripping. It is not known why mutual funds have been specially targeted for an extended period of holding. The law could have been uniform for equity shares too.

A precondition for applying the law against dividend stripping is that such dividend is tax exempt. One only has to refer to Sections 115-O and 115R and the exemption for dividend under Section 10 of the Act.

While dividend received by shareholders and unit-holders is not included in their income, there is a tax on distribution of dividends in the hands of the companies.

The tax is, therefore, paid at the point of distribution by the company and exempted in the hands of shareholders.

It has been argued by tax analysts that the dividend is thus taxed and, therefore, the vital condition of Section 94(7) is not fulfilled. If this logic is accepted by the courts, then the whole scheme of Section 94(7) may fail.

If the entire lot of units (both the original and the bonus units) are sold, then the new provisions may not be attracted. Yet another incongruity is that for an honest investor, the cost of acquisition unit will be nil as per Section 55(2)(iiia) of the Act, but somebody manipulating the law may have the resultant loss on sale of bonus-stripped units added to the cost of bonus units.

When the Budget proposals were announced, even though the law regarding capital gains taxation was welcomed by one and all, the mutual fund industry protested against discrimination involved in the amendment.

The Finance Minister, therefore, made a statement in the Lok Sabha on July 21, 2004, proposing to treat "units" as "securities" and extend the benefit of the new capital gains tax regime to such unit-holders.

The Finance Act makes it clear that it will be no longer be necessary to refer to Section 2(h) of the Securities Contract Regulation Act, 1956, for claiming the relief.

To that extent, the discriminatory provisions have been modified but still the fact remains that there is discrimination in this Budget against the mutual fund industry.

Dividends and bonus stripping are devices long established to avoid tax.

In the leading case of Griffiths vs Harrison (1963 AC 1), a dividend stripping transaction entered into for tax avoidance was considered and Lord Denning in his dissenting judgment observed that the law was entitled "to see people as they really are, prospectors digging for wealth in the subterranean passages of the Revenue, searching for tax repayments."

Bonus and dividend stripping transactions are bad if used for tax avoidance.

But the taxpayer has a right to expect clarity and the uniformity in law between shares and units. Obviously, the Finance Ministry has not done its homework well.

(The author is a former chief commissioner of income-tax.)

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