Saving on taxes is not a big problem if one has the means to do it within the limits of law. Investors who have made short-term profits in ‘high-gain’ asset classes like equities, real estate and bullion are going all out to save on taxes. Affluent investors are resorting to ‘dividend stripping’ to set off their gains against “managed” losses arising in mutual fund portfolios.
According to distributors, almost all fund houses are allowing their high net worth clients to set off short-term losses. Not legally forbidden, dividend-stripping allows affluent investors to earn dividends on their short-term investments and also a ‘notional loss’, which they can adjust against other short-term gains.
The strategy is bad for long-term investors (in dividend-stripped funds), as they will have to share their portion of dividends with new entrants who invest only for tax arbitrage.
The over 115% rise in equities this year — along with 40% gain in bullion and a 25% appreciation in real estate prices — has resulted in huge short-term capital gains for investors, say wealth managers. Several investors have recorded short-term capital gains, as they sold equities within one year of buying them.
In the case of real estate (and other assets like bullion and precious), short-term capital gain (or loss) stays for the first three years of buying the asset. Dividend-stripping is a method of avoiding tax by buying securities or units of mutual fund before the record date and selling them after the record date.
By buying the securities, the investor will get dividend and by selling it, the short-term capital loss incurred can be set off against a short-term capital gain, thereby reducing his tax liability.
The modus operandi is simple. Fund houses set the record date seven days prior to the date of declaration of dividend. The rule states that investors who enter that particular scheme three months before the record date, can avail a tax-free dividend pay-out. The fund house, for the benefit of its ‘privileged’ investors (mainly HNIs), discreetly lets out its intention to pay dividend four months before the date of dividend declaration.
Affluent investors are encouraged to invest more money into schemes that will declare dividends about 90 days later. On the date of dividend declaration, the net asset value (NAV) of the fund will witness a fall.
The investor exits the scheme (sells the portfolio) at a lower NAV, immediately after pocketing the dividend.
The portfolio sell-off will result in short-term capital loss (to the extent of the difference between the NAV when he entered the scheme and at the time of exit). On paper, the investor suffers a loss in capital. But if one looks closer, the investor has collected tax-free dividend and also gets a chance to set off capital gains (on other investments) against this ‘notional loss’ incurred on his mutual fund portfolio.