Personal Finance: The Strip Club

PERSONAL FINANCE: MUTUAL FUNDS
The Strip Club
It's embarrassing if you are caught doing it, although there's nothing illegal about it. What is dividend-stripping, and should you be doing it too? Shilpa Nayak finds out.

I have heard hushed voices talk about dividend-stripping. Do I need to be over 18 before anybody will let me into it?

No. Dividend-stripping has nothing to do with Gentlemen's Club. Rather, it involves a simple exercise of buying mutual fund units just ahead of the record date for declaration of dividend, and selling them right back after the record date is over. Why do people do it? Simply because dividend income at the hands of investor is tax exempt. Therefore, by making that short-lived deal, they get a tax break for one whole financial year.

Give me an example...

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Say, you invest Rs 1 lakh in a mutual funds scheme at a net asset value (NAV) of Rs 20. You get 5,000 units. Assuming that the fund declares a dividend of 50 per cent (on par value, which typically is Rs 10) for the year in March, you will get Rs 5 per unit as dividend, totaling to Rs 25,000. Ten days hence, that is post-record date, the nav will fall, since many short-term investors would have sold their investments at the post-dividend price, which in this case should be Rs 15. Of course, you lose Rs 5 per unit when you sell at this price, but don't forget that you have already received a dividend of Rs 5 per unit. This transaction helps in two ways: One, it throws up a loss that you can use to offset other capital gain and two, it gives you a Rs 5 component in your earnings that is absolutely tax free.

Who loses or who gains?

The government loses (an estimated Rs 5,000 crore each year), and large corporates, high networth individuals, and stockbrokers, who account for a chunk of such deals, gain the most. Some funds abet the process because they gain on two counts. One, there is a massive inflow of funds around the time that dividend is declared. And two, it helps them earn large interest income by parking the funds in short-term instruments.

Sounds good. Should I, the small investor, do it too?

You could, but it doesn't make much sense in your case. The reason why big-ticket investors do it is the huge notional loss they are able to book against their capital gains. The figure could run into several lakhs or a few crore of rupees. In your case, it would be a few thousands of rupees. Therefore, the savings won't be worth the trouble. Besides, as my friend Ajit Sanghvi, a Mumbai-based stock broker points out: ''Although dividend-stripping is perfectly legal, it is an unhealthy practice, AMD unfair to the honest tax-payer.''

Why don't funds put an end to it?

Some funds do discourage dividend-stripping, but don't forget that doing so is not illegal. There's a downside to such 'hot money'-it disappears as fast as it came in. Therefore, while a fund may be tempted to make a quick buck overnight, it can't afford to tie up the fresh money into any long-term investment. The mutual fund community is now counting on SEBI to do something about it, by either banning it outright or slapping heavy loads (or fee) on entry and exit into funds at the dividend time.

Does Budget: 2001 help?

Short-term losses created to offset tax outgo will now be curbed by introduction of a new sub-section (7) under Section 94 of income Tax Act. If you buy securities or units within three months of the record date and sell it before three months after the date of closure, the loss arising from such a transaction will not be included in computing the tax on income. However, if the loss is greater than the dividend received, the balance can be used to offset other gains. The proposed amendment will be effective from April 1, 2002.

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