Dividend stripping: tax avoidance at the cost of small investors

Mutual Funds are known for their gimmicks to woo investors� attention to get as much funds as possible under their folio. Announcement of dividends well in advance, which was the innovation of Kothari Pioneer Mutual Fund, is one way of doing so. The mutual fund announces dividend in advance to woo HNIs who invest in huge quantum for a very small period and withdraws the amount after receiving the tax-free dividend and booking short term capital loss. This short- term capital loss can be adjusted against any short- term capital gains booked in that financial year. This has become a very good mode of tax avoidance and more and more mutual fund houses are joining the bandwagon of encouraging such practices. It is a win-win situation for the new investors as well as the AMC. The investor gains in terms of post tax returns, while the AMC gains by charging exit and entry loads from the investors.

But then who is the loser? The main loser is the exchequer that is losing in terms of the revenue, which otherwise would have come to its pocket by way of Income Tax. But this is the benefit extended to the investors of mutual funds by the Law and can be perceived as a way of tax planning and hence can not be challenged. However, "it is not in the spirit of law," says Mr. Suraj Mishra, Vice President - Marketing, Prudential ICICI Mutual Fund, one of the funds who are strictly against the concept of dividend stripping. "We announce the record date just 5 days in advance and the quantum of dividend is announced only after 3.00 P.M on the record date. Further, we also have an exit load to avoid such a practice." Adds Mr. Mishra.

How do existing investors lose? The existing investors of equity funds lose in the period of rising stock market and gain in the period of declining stock market. The collection during the period of dividend announcement is normally invested in money market instruments earning minimal amount in terms of interest income. The corpus of the existing unit holders are invested in stocks after appropriating for the quantum of the dividend that has to be distributed. In case of rising market phase the return generated by the equity portion of the portfolio is much more than that from the liquid portion that is invested in money market. But in terms of returns, the new investors are not segregated from the existing unit holders and the return from the equity portion of the portfolio gets distributed among the entire unit holders. Hence the new investors get the share of the goodies of the equity portion of the portfolio also for which they are not actually entitled to. "The inflows increase the cash position of the fund and effects the returns of its existing investors," says Mr. Mishra. These benefits get reversed in the case of falling market phase. In case of the debt funds the market is normally less volatile and hence the existing unit holders lose at the cost of dividend strippers by and large.

How do investors benefit? The new investors who come into the fund are normally in the highest tax bracket paying taxes at the highest rate. In case of equity and balanced funds, dividends are tax free at the hands of the investors as well as the mutual funds. So, the decline in NAV after dividend is normally tantamount to the dividend received from the funds. So the cost of converting the taxable amount into tax-free amount is the entry and exit load that are charged by the AMCs and is normally in the range of not more than 4 percent. In case of debt funds the AMC has to pay dividend distribution tax at the rate of 22% and in turn extended to the unit holders in terms of a drop in the NAV. But the HNIs who have to pay taxes at the rate of 33% benefit from dividends again as they are paying lesser amount even after adjusting for the loads and dividend distribution tax.

Why do the AMCs follow this? The AMCs benefit in terms of the load charged by the unit holders. It is difficult to understand why SEBI has not taken any stand on this issue up till now. Both SEBI and AMFI, who boast of being the watchdogs of mutual fund industry, are mum on the issue. There are some mutual fund houses that have imbibed to the policy of safeguarding the investors� interest. Some of the AMCs used to impose contingent deferred sales charge to discourage dividend strippers in debt funds but such practices do not deter those in equity funds. Kotak Mahindra Mutual Fund, Templeton Mutual Fund and Prudential ICICI Mutual Fund are the examples that do not indulge into such practices. A fund manager of a mutual fund, which has not indulged into this policy said, "dividend stripping should be discouraged by mutual funds because the very objective of facilitating small investors savings is lost as dividend strippers gain at the cost of small investors."

Recently Sun F&C Mutual Fund is reported to have garnered above Rs. 1200 crores when it announced a dividend of 35 percent and charged an entry load of 1.75 percent and an exit load of 1.5 percent. Kothari Pioneer had also mobilised hundreds of crores on dividend announcements of 25 percent each in two of its schemes Prima and Prima Plus. The fund is known to have charged around 2.75 percent in terms of loads to the dividend strippers who wanted to convert their taxable money into tax-free capital.

Dividend stripping always has a cost, which is borne by innocent small investors who invest in funds with long term horizon. It is a malpractice in the industry that should be checked immediately so as to safeguard the interest of retail investors.