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July 14, 2010 Supreme Court Approves Dividend Stripping Transaction and Consequent Losses as Genuine In its recent ruling of CIT, Mumbai v. M/s Walfort Share and Stock Brokers Pvt. Ltd.1, the Supreme Court of India (“Court”) has held that losses arising from the purchase and transfer of units of a mutual fund (“Units”), on which dividends have been freshly paid (also known as ‘dividend stripping’), are genuine. The Court, dealing with a bunch of Special Leave Petitions (“SLPs”), held that a dividend-stripping transaction was permissible under law and losses arising from it were available to be set off against the income of the taxpayer, to the extent permissible by law. What is Dividend Stripping? In simple terms, dividend stripping refers to transacting in shares or securities linked to shares of a company on which dividend is payable. Typically, a dividend stripping transaction involves the following steps: 1) Purchase of securities/ units linked to shares of a company on which dividend is payable, at a price, say INR100 2) Holding on the investment in the above securities/ securities linked to shares of a company and enjoying the benefit of dividend distributed on such investment, say INR 10. 3) Sale of the securities/ units linked to shares of a company at a lower price, say INR 85. This fall in price of the shares/ units linked to shares 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 ITA, dividend distributed by a company is not taxable in the hands of its shareholders. Further, the taxpayer may claim a carry forward or set off of the loss arising from selling the shares/ units linked to shares of a company at a lower price. Interestingly, section 94(7) of the ITA 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 shares of a company. In effect, in the above example the taxpayer would have incurred a loss of INR 15 by virtue of sale and purchase of the shares (100-85 = 15), however by virtue of section 94(7), only INR 5 (15 – 10 = 5) would be available as loss for set of and carry forward purposes. Analysis of the Ruling The taxpayer in the lead matter had claimed set-off of the losses arising from the sale of dividend stripped Units at a price lower than the purchase price, against his income in the assessment year 2000-2001. Deleting the losses, the Assessing Officer (“AO”) held that the taxpayer had engaged into a dividend stripping transaction, which was not a business transaction, and was entered into primarily for tax avoidance. The Commissioner of Income Tax, Appeals (“CIT (A)”) upheld the AO’s decision. The Income Tax Appellate Tribunal and the High Court disagreed with the decision of the AO and the CIT (A). The contention of the revenue, before the Court, justifying the deletion of losses was twofold: 1) The investment of the taxpayer constituted of two separate assets (i) the tax free dividends and (ii) the ex-dividend Units. The revenue contented that the difference between the purchase and the sale price of the Units (i.e. the loss) is nothing but expense incurred for earning tax free dividends. Therefore by virtue of section 14A, such expense is not allowed for deduction from income. The revenue further argued that section 94(7) did not nullify the application of section 14A to the case at hand since it was only introduced prospectively with effect from April 1, 2002, and could not retrospectively apply to assessment year 2000-2001, for which the taxpayer had raised a dispute. 2) The amount received by the taxpayer as ‘dividends’, in fact and in law, constituted a ‘return of investment’ in the hands of the taxpayer. Therefore, the said amount was required to be adjusted against the cost of purchase of the original Units. Hence, there is no loss suffered by the taxpayer on subsequent sale of Units. Rejecting the arguments of the revenue, the Court held that ‘expenditure’, ‘return on investment’ and ‘cost of acquisition’ are different concepts in law. Expenditure, under the scheme of the ITA, is expenditure on rent, taxes, salaries, interests etc. and is debit in real sense. Therefore a pay back or return of investment cannot be expenditure. Therefore section 14A cannot be applied in case of a return of investment. As regards the second contention of the revenue, the Court held that a mere receipt of dividend after purchase of the Units could not go to offset the cost of acquisition of the purchase of the Units. The Court also held that sections 14A and 94(7) applied in different fields and there was no overlap between them. While section 14A of the ITA applied to the case of expenditure incurred in earning non-taxable income, section 94(7) applied to losses. Since section 94(7) was prospectively introduced effective from April 1, 2002, losses arising out of dividend stripping after that date would be ignored to the extent of the dividend earned. The Court observed that the essence of revenue’s objections was that the taxpayer had purposely entered into a pre-meditated tax avoidance transaction of buying and selling units yielding exempted dividends, with full knowledge about the fall in their net asset value after the dividend payment. The Court acknowledged that the so called dividend-stripping transaction was permissible under law, subject to the application of section 94(7), and at worse amounted to tax planning. The Court sought support from its landmark ruling in Union of India v. Azadi Bachao Andolan2, to hold that the taxpayer was free to carry on its business within the four corners of law. Conclusion The above analyzed ruling is noteworthy for two reasons. Firstly, the Supreme Court of India upheld the validity of dividend stripping transactions, as permissible affair under tax laws. Secondly, this ruling is yet another recognition of the distinction between tax avoidance and tax planning. The Supreme Court 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 Indian judiciary has endeavored to grant finality to the principle of validity of tax planning time and again; however its heartfelt acceptance by the executive is long due. Having said the above, it is important to note that the Indian government is planning to introduce the Direct Tax Code (“DTC”) in the monsoon session of the Parliament, starting from July 26, 2010. The DTC proposes to introduce a 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. The GAAR provisions are proposed to override the other provisions of the DTC. 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. __________________ 1 Civil Appeal No 4927 of 2010
You may direct your comments to Ramya Krishnan-AniL +91 900465 0363 |
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