Supreme Court rules taxpayers can legally reduce their liability through dividend-stripping

In a significant ruling, the Supreme Court has ruled that taxpayers can legally reduce their liability through dividend-stripping, a term used for selling mutual fund units at a discount post-dividend. An apex court bench headed by Chief Justice SH Kapadia has said there is nothing wrong in dividend-stripping after getting the tax benefits. The bench further said such dividend stripping after availing of the tax rebates cannot be termed as abuse of law.

“Even assuming that the transaction was pre-planned there is nothing to impeach the genuineness of the transaction,” said the bench agreeing with an earlier Bombay High Court order.

Dividend-stripping is purchase of shares just before a dividend is paid, and sale of the same after that payment, when they go ex-dividend. This is often done by investors and corporate houses as an investment strategy to avoid/reduce income tax liability.

The court further said the income tax department cannot term the loss occurred after such transaction is not a valid transaction as it has been pre-planned one.

The bench further said the interest/dividend received on such investments are regarded as “return on investment and not return of investment”.

The court also said only in certain cases where the purchase price includes the right to receive “crystallised and accrued dividend, that have already accrued and become due for payment before the date of purchase of the units, that the same has got be reduced from the purchase of the investment”.

But mere receipt of dividend subsequent to purchase of units “merely on the basis of a person holding units at the time of the declaration of the dividend on the record date cannot go to offset the cost of acquisition of the units”, pointed out the court.

The order came over a petition filed by the IT department challenging the orders of the Bombay High Court. The case dates back to 2000, when the brokerage house Walfort Share & Stock had bought tax-free dividends from Chola Freedom Technology Mutual Fund at a unit price of Rs 17.23. As per the terms and conditions, the brokerage house got 40 percent tax concession from the deal.

Three days after the deal, they sold it at Rs 13.23 a unit, thus incurring losses. When the firm filed its annual returns then it got the benefits under section 10 (33) of the Income Tax Act, but the department declined to adjust the loss suffered in dividend-stripping, contending that it was not a business transaction but a pre-designed artificial loss.