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Can dividends lead to a capital loss? Well looks like it. Finding a legal loophole, dividends declared by mutual funds are used as a means for writing of losses. In his budget of 1999, the FM had succumbed to the pressure of public demand and made the dividends declared by equity mutual funds tax free. Availing of this gesture, the clever and devious investor has today found a way to abuse this exemption.

The modus operandi is thus - a mutual fund declares an attractive dividend, the record date for which is some days later, so in a manner the dividend has been declared in advance. Seeing this opportunity the HNI (High Networth Individual), invests substantially in that MF a day before the record date. Soon after the MF dividend is collected, the investment flows out (normally one day after the record date). The HNI sells the units. Now due to the dividend flow out from the fund’s cash balances, the NAV or net asset value of the fund falls, so his sale price is less than the price he had purchased the units at. This leads to a loss, short term capital loss, which can be written off against any capital profit for the year.

So, who gains in this game - the fund of course gains, because it has an entry load -a certain percentage you pay when you enter the fund and an exit load - the percentage you pay when you exit the fund. The HNI gains because, he has managed to earn a tax free dividend plus a capital loss, which he can offset against any other capital gains made during the year, thereby further reducing his tax liability.

The only loser is the government which loses out on many crores which slip out of the tax net due to capital losses, which are used to write of the capital gains. One sure way of substantiating this game is to have a look at the inflows and outflows closer to the time of the record date. Normally in October and December, the months in which the funds announce dividends, there is a lot of activity.

One way of curtailing this irresponsible practice is to follow the Prudential ICICI method, where the fund declares the dividend after the close of the markets on the record date. The other way adopted is to insist on a lock in period of some days as is done by Alliance and Birla etc. Above all HNI and the MF industry should avoid taking advantage of a legal loophole to abuse the privilege given, otherwise, sooner or later this privilege will be withdrawn or diluted. 

Example

Mr.X has earned RS 10,00,000.
On this he has to pay a tax of 34.5%-i.e.-RS 3,45,000.
Instead of paying the same he invests this RS 10,00,000 in a MF which has declared a dividend of 30%.
So he earns a tax free income of RS 300,000 as dividends.
The NAV of the units he had purchased fall by 30%, so he has a capital loss of RS 300,000.
He can set off this capital loss against any capital gain made during the year.
So, he benefits by saving capital gains as well as by earning tax free income.

Aru Srivastava

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