CAN THE INVESTOR STRIP???

Aditya Khemka
Management Development Institute, Gurgaon

Previously, dividends were taxed but then came in the arguments against double
taxation of corporate profits. The point put forward was that first the corporate profits are
taxed by way of income tax. Then the profits are appropriated by the corporate to pay
dividend and then the dividend was being taxed by way of a dividend tax. Thus, the same
amount of money was taxed twice and the investors were the losers. So, the government
decided to lift the dividend tax and opened a loop hole for the INTELLIGENT Indian
investors.
Thus started a process called Dividend Stripping. The investor is supposed to
pay capital gains tax on the shares he sells for a profit. Because of the short term beliefs
held by most of the investors the capital gain is mostly short term that is less than one
year has expired between the purchase and sell of the shares in this case. The short term
capital gains can be set off by short term capital losses made in the same context. So if an
investor could make a loss without actually suffering it, he would evade the capital gains
tax.
In order to do so, investors started purchasing shares which had a proposed
dividend. As soon as the dividend is declared the share prices shoot up approximately by
the amount of the dividend. Then when the stock goes ex dividend the prices fall by the
same amount and the investor sold the stock at that price which was lower than the
purchase price.
Note that the difference between the two had already been received by the
investor in terms of dividend. So he accrued a short term capital loss in the books of
accounts without having to suffer any loss actually. Thus, he successfully strips himself
of the profit by taking untaxed dividend.
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In the above example, the dividend is declared on 1st, the investors buys the stock
on the 2nd at Rs.104 and sells the same on 12th for Rs.100 while also receiving a dividend
of Rs.5 at the same date. Thus he ends up with a capital loss of Rs.4 per share without
actually suffering any loss at all and thus evades tax on profit made on other investments.

But, the above example is of no use today. Since the dividend tax has been
reinstated dividend stripping is of no use because the investor has to pay tax on dividend
if he evades tax on capital gains. But we are INTELLIGENT investors, so there is
another way. This is Bonus stripping.
When a corporate decides to issue a bonus share the price of the share falls
proportionately. Thus similar to the case of dividends cited above, when a bonus is
declared the share prices of the company do rise a little if it meets the market
expectations. However, unlike the case of dividends it is not always true. The share prices
may remain unaffected or even fall after a bonus is declared.
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Here, the bonus is declared on the 2nd, the investor buys the 100 shares say on the
4th at Rs.325. On 9th the stock goes ex bonus and thus the share prices fall in the ratio of
1:2. That is 2 bonus shares received for 1 share held. Thus now the share price is Rs.112
exactly 1/3rd of the price of the previous day Rs.336. Thus now the investor sells the 100
shares at a loss of Rs.213 per share. The cost of the bonus shares is taken to be Rs.0
according to the income tax rules.
In the recently announced budget the long term capital gain tax has been
abolished for shares with effect from 1st October 2004. Thus the investor can hold the rest
200 shares for a year and then sell them accruing a non taxable long term capital gain.
Thus we see that in this example the investor can get himself stripped of a capital
gain of Rs.21300 by investing Rs.32500 and not loosing anything in the process. As in
the current scenario he was supposed to pay a 10% short term capital gain on the same
amount which comes to Rs.2130. And the net amount invested for 1 year is actually only
Rs. 21300. Thus by saving Rs. 2130 he has in effect earned a return of 10% on his
investment not including whatever price appreciation or dividend he might get for
holding the shares for 1 year.
The difference from dividend stripping lies in the fact that the investor has to tie
himself with bonus shares of the company for a year. So the only extra burden he has to
take is to find a company that is stable and has good long term prospects. Have a happy
time investing and save & earn….rather evade & earn.