Dividend Stripping has created dual benefits for the short term investors in the form of tax free dividends and booking notional short-term losses. What is dividend stripping, who are the losers and gainers by this? Dividend Stripping is a concept of investing in a fund from the date of declaration of dividend till the record date and selling back the units after the record date thus booking tax-free income and capital loss to save taxes on other income. This is often practiced by corporates, high net worth investors and stock brokers at the expense of the long-term investors.

Normally in mutual funds, the NAV increases till the dividend distribution and the ex-dividend NAV will be lower and will result in a loss to the investor if units are sold soon thereafter. Therefore this results not only in a tax-free dividend but also a short-term capital loss which is notional. However, this is suited well for open ended and equity funds (which are tax free unlike debt funds which are charged a tax of 22%).

Overcoming dividend stripping

There are few measures to avoid this dividend stripping. One of it could be by reducing the repurchase price of the funds. However, this may cause a lot of disappointment to the other investors and may create panic conditions to the investors. Another measure is introduction of higher entry load around the time of the record date and a higher exit load for the period immediately after the dividend payout. Another solution can be the principle followed by Zurich AMC for its Zurich India Top 200 Fund recently. The dividend rate and record date were announced by the AMC on the 12^th January, 2000 with the record date as 7^th January, 2000. This did not give any chance for dividend stripping, as the record date was passed and only the investors on a date prior to the declaration date could be entitled to the dividends.

SEBI regulations stipulate that dividends ought to be declared by the trustees of a mutual fund on the basis of profits earned by capital gains for the period under consideration and not out of the profit earned at a different time. SEBI also has observed that some mutual funds helped the dividend strippers by crediting a major portion of the proceeds from sale of units above the par value to the income equalization account instead of Reserves account and this money is being distributed as dividends in times of poor performance. It means that these AMCs are giving dividends out of the capital instead of actual profits.

For instance, a mutual fund that sells units at say Rs 50, credits Rs10 to unit capital, Rs 10 to reserves and the balance Rs 30 to the income equalization account. And this Rs 30 is being used to give dividends. In reality, the mutual fund should have credited Rs 30 to the reserves account which could not be used for dividends unless in case of an emergency. With all these measures and involvement of SEBI, there may be some relief to the long term investors and the proper paying of taxes by the corporates and high networth investors. However, the stoppage of flow of capital gains into income equalization account by AMCs is something to be watched out, which would obviously reduce the dividend stripping.

The question then is why is Sebi bothered and what can it do? Obviously the dividend stripping is distorting mutual fund collections which are not being reflective of actual retail interest in these investment instruments. Secondly, mutual funds are designed for the benefit of the retail investors and the high net worth investors and corporate seem to be making hay at the cost of the retail investors. It is high time Sebi reconsiders the issue of keeping dividends on equity funds totally tax free. This would be the one measure that will be instrumental in reducing the incidence of dividend stripping.

K Venu Babu