A dividend stripping transaction is lucrative for a taxpayer since by virtue of section 10 (33) of the Income Tax Act. The Government of India is in the process to implement General Anti Avoidance Rule (“GAAR”), This will take care of Dividend stripping.
To understand it better, I will start the answer with a small Illustration and proceed with the answer further with analysis of the relevant sections, Accounting standards and case studies involved in various case laws.
Mr. A purchase of securities/units linked to share of a company on which dividend is payable, at a price, say Rs. 1000. Mr. A by holding on the investment in the above securities/securities linked to share of a company enjoying the benefit of dividend distributed on such investment, say Rs. 100. Mr. A sale these securities/units linked to shares of a company at a lower price, say Rs. 850. This fall in price of the shares/units linked to share of a company is largely attributable to the dividend payout.
A dividend stripping transaction is particularly lucrative for a taxpayer since by virtue of section 10 (33) of the Income Tax Act, dividend distributed by a company is not taxable in the hands of its shareholders. Further the taxpayer may claim a carry forward or setoff of the loss arising from selling the shares/units linked to shares of a company at a lower price. Another section 94(7) of the Income Tax Act provides that only so much of loss is available for set-off or carry forward, which exceeds the amount of dividend earned on the shares/units linked to share of a company. In effect, in the above mentioned example the taxpayer would have incurred a loss of Rs. 150 by virtue of sale and purchase of shares (Rs.1000-Rs.850= Rs.150), however by virtue of section 94(7), only Rs. 50 (Rs.150-Rs.100) would be available as loss for set off and carry forward purposes.
Analysis of relevant Sections:-
1. Section 14A:-
For the purpose of computing the total income under this Chapter, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under this Act.
The fundamental principle underlying in sec. 14A is that income which is not taxable or exempt falls in a separate stream distinct from income taxable under the Act. That, expenditure which is incurred in relation to income subject to tax would be admissible under Sections 30 to 43B whereas expenditure incurred to earn exempt income would be extraneous in the computation of taxable income under the Act. Thus, only that expenditure is deductible which is incurred in relation to business or profession. Expenditure producing non-taxable income would not be permitted to be claimed as admissible expenditure. Thus, in all cases where the assessee has some exempt income, his total expenditure has got to be apportioned between taxable income and exempt income and the latter would have to be disallowed.
In the case of ACIT Vs. Dakshesh S. Shah [(2004) 90-ITD-519 (Mum.)] the High Court held that sec. 14A is part of Chapter IV and it applies to expenditure referable to any head of income referred to in sec. 14. Sec. 14A is couched in specific terms which does not leave any room for doubt or dispute with regard to the fact that in order to claim deduction of expenditure in relation to a particular income, the assessee has to show that the said income forms part of total income.
2. Section 94(7)
As per sec. 94(7), where-
a) Any person buys or acquires any security or unit within a period of three months prior to record date;
(i) Such person sells or transfer such securities with in a period of three months after such date or
(ii) Transfers such units within a period of 9 months after such record date;
c) The dividend or income on such securities or unit received or receivable by such person is exempted,
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.
All the three conditions must be satisfied before sec. 94(7) is attracted. Thus, if the shares are acquired before the period of three months prior to record date, section 94 (7) shall not apply. Similarly, if such shares are sold after three months of the record date, section 94(7) shall not be applicable.
‘Record date’ means such date as may be fixed by a company or a Mutual Fund or the Unit Trust of India for the purpose of entitlement of the holder of the securities or the unit holder to receive dividend or income, as the case may be.
Difference between Sec. 14A and 94(7):-
As regards the reconciliation of sec.14A and sec.94(7), the two operate in different fields. Sec. 14A deals with disallowance of expenditure incurred in earning tax-free income while Sec. 94(7) refers to disallowance of loss on acquisition of an asset. Sec. 14A applies to cases where an assessee incurs expenditure to earn tax free income but where there is no acquisition of an asset. In cases falling u/s 94(7), there is acquisition of an asset and existence of the loss which arises at a point of time subsequent to the purchase of units and receipt of exempt income. It occurs only when the sale takes place. Sec. 14A comes in when there is claim for deduction of an expenditure whereas Sec. 94(7) comes in when there is claim for allowance for the business loss. Sec. 14A and Sec.94(7) were inserted by the Finance Act, 2001, Sec. 14A was inserted w.e.f. 1.4.1962 while Sec. 94(7) was inserted w.e.f. 1.4.2002.
Accounting Standard 13:- Accounting Standard 13 provides that interest/ dividends received on investments are generally regarded as return on investment and not return of investment and it is only in certain circumstances where the purchase price includes the right to receive crystallized and accrued dividends/ interest, that have already accrued and become due for payment before the date of purchase of the units, that the same has got to be reduced from the purchase cost of the investment. A mere receipt of dividend subsequent to purchase of units, on the basis of a person holding units at the time of declaration of dividend on the record date, cannot go to offset the cost of acquisition of the units.
1. CIT Vs. Walfort Share and Stock Brokers P. Ltd. [Civil Appeal No. 4927 of 2010 (SC)]
Walfort Share and Stock Brokers P. Ltd purchased units of Chola Freedom Technology Mutual Fund on March 24, 2000. This was the record date for declaring dividend. The company became entitled to a dividend at Rs 4 per unit and the amount earned was Rs 1,82,12,862. The NAV (net asset value) stood at Rs 17.23 on this date. It fell to Rs 13.23 soon after declaration of the dividend. The company sold all the units on March 27, 2000. It received an incentive of Rs 23,76,778 for the transaction. In its income-tax return, the company claimed exemption of the dividend amount of Rs 1,82,12,862 under Section 10(33) of the I-T Act. It also claimed a set-off of Rs 2,09,44,793 as loss incurred on the sale of units.
The assessing officer (AO) disallowed this loss. He pointed out that this was a dividend stripping transaction and not a business transaction. It was entered into primarily for the purpose of tax avoidance. The loss was artificially created by a pre-designed set of transactions. Matter went to Supreme Court.
Supreme Court dismissed the SLP and held that loss incurred by the Taxpayer in ‘dividend-stripping’ transaction cannot be disallowed for year prior to the introduction of specific anti-avoidance provisions in the Income tax laws. The Supreme Court further held that once it is established that there was actual investment and sale, the fact that tax-free dividend was received did not affect the quantum of loss incurred. In view of the Supreme Court, the use of provision of the Income tax Laws by the Taxpayer to obtain a tax advantage was not abuse of law and the loss arising was admissible as the transaction of purchase and sale was real.
2. UOI Vs.Azadi Bachao Andolan [(2003) 263-ITR-706 (SC)]
The apex court clearly held that legitimate tax planning cannot be challenged merely on the basis of assumed underlying intentions of tax evasion. The court, commenting on the McDowell’s decision whilst referring to various other judgments, agreed that not every action or inaction on the part of the taxpayer, while results in reduction of tax liability, must be viewed with suspicion. Taxpayers are free to carry out any trade/activity or plan his affairs with circumspection, within the frame work of law, unless the same falls in the category of a colorable device without substance. So principally, the right of taxpayer to “plan” his transactions to mitigate tax liability cannot be questioned only because it is “tax advantaged” provided “economic substance” is demonstrated in the same. However, if the motive of the tax avoidance is seen to outweigh the purpose of the transaction evidenced and evaluated with factual aspects, the Courts in India more likely than not will tread the path of assuming that “substance over form” should prevail and the transaction should be challenged.
In the case of Wallfort share and stock brokers Pvt. Ltd. the Supreme Court of India has reiterated that tax planning is perfectly valid, since it is within the four corners of law. However, the revenue department has time and again attempted to tax legally permissible transactions as tax avoidance mechanism. The Governent of India is in the process to introduce General Anti Avoidance Rule (“GAAR”), which could empower tax authorities to re-characterize a transaction entered into by a taxpayer and the income there from. Currently tax planning is considered as legal in light of the Azadi Bachao Andolan case. However, it remains to be seen how GAAR would impact tax planning by taxpayers, including in cases of dividend stripping.
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