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A win-win situation

Dividend stripping

With the Finance Bill 1999 making the dividends from mutual funds tax free, it created a dual benefit for short-term investors: dividend stripping opportunity, and booking notional short-term losses. It is like having the cake and eating it, too.

What is dividend stripping? Assume that you invest in a no load fund just before the record date for dividend distribution and exit the fund soon after dividend distribution. Assuming that in the interim, the NAV moves only to the extent of the dividend distribution, the ex-dividend NAV will be lower and will result in a loss for the investor if sold soon thereafter. Therefore, this results not only in a tax-free dividend, but also a short-term capital loss that is only notional.

To understand better, let us consider the example of a fund declaring an 80 per cent dividend, say, with a record date as March 22, 2000. An investment of Rs 10,000 at the NAV of, say, Rs 81.93 as on March 8, will result in owning 122.055 units. At the time of exit from the fund soon after the dividend, the NAV will be Rs 73.93 with a fall of Rs 8 per unit on account of dividend distribution. The investor, thus, gets a tax-free dividend of Rs 976 and on the immediate sale of the units, proceeds of Rs 9,024 resulting in a capital loss of Rs 976.

Hence, the investor is able to maintain the status quo of his investments i.e. invested 10,000 and got back 10,000 and that too with a notional capital loss. This short-term capital loss can be used to set off short-term and/or long-term capital gains and balance if any can be carried forward for eight years for set off in the later years.

But often, funds introduce an exit/entry load for short-term periods to discourage dividend stripping. In such a case, dividend stripping will only be possible if, during the stay in the fund, there is an upward movement in the NAV by the same percentage as the load suffered by the investor. This will result in a higher ex-dividend NAV and give the same results as in the first case. Let us suppose there was a 2 per cent exit load in the above example.

Consider a 2 per cent gain in the NAV to Rs 83.57 during the stay in the fund. With an 80 per cent dividend, the ex-dividend NAV will be Rs 75.57. After the 2 per cent exit load, the per-unit NAV will be Rs 74.057 resulting in proceeds of Rs 9,039, apart from the tax-free dividend of Rs 976.

Further, if the fund also declares a bonus issue along with dividend, that will be just the icing on the cake. Let us improvise the second example to include a 1:1 bonus as well. This will imply an ex-dividend and an ex-bonus NAV of Rs 37.785 and 244.1108 units (twice the original units). Now, if the investor sells the original 122.0554 units @ 37.785, the transaction will result in proceeds of Rs 4,612, thus a notional short-term capital loss as high as Rs 5,388.

Since in the case of bonus units the total sale price will be capital gains, it makes sense to sell them after 12 months. This not only defers the tax liability, but also taxes the gains at a reduced rate of 11 per cent (10 per cent + surcharge). There can be other benefits too, like setting off in the next financial year capital loss from any other transaction or avail benefit of basic exemption limit if income in next year is expected to be lower.

But the strategy can be as simple only if there is very little uncertainty about the assumptions turning out to be actually true. An inherent risk which, the investors will have to assume would be a turn in the tide of the markets. This may also result in the dilution of the investments. But the rising trend in the markets since the beginning of '99, despite the volatility, has reduced the risk of a downturn in the bourses. This has increased the appeal of dividend stripping.

Though dividend stripping can be successfully adopted for open-end funds with more than 50 per cent allocation to equity, for other funds it may not be true. The other funds have to pay 11 per cent additional tax (increased to 22 per cent with effect from April 2000) on proposed dividend, thereby reducing the actual distributable surplus for the investors.

Hence, investors of debt funds or other funds with less than 50 per cent allocation to equity should only opt for growth option which does not pay any dividend but re-deploys the earnings of the scheme, thereby enhancing its NAV. Whenever the units are en-cashed, capital gain arises. However, it will be better for investors to encase after 12 months so that the resultant gain is taxed @11 per cent.

THE DIVIDEND STRIP SHOWCASE

Scheme Name	Dividend (%)	Bonus	Record Date	NAV (9/3/2000)	Load / Type	Div' Yield
Kothari Taxshield	80%	-	31-Mar	33.55	No load	23.85
Prudential ICICI Tax Plan	60%	-	17-Mar	26.11	1%, Entry	22.98
Libra Leap	101%	-	17-Mar	48.45	2%, Entry	20.85
Kothari Bluechip	65%	1:1	14-Mar	51.49	2%, Entry	12.62
UGS 10000	20%	-	21-Mar	16.58	3%, Entry	12.06
Birla Advantage	80%	-	22-Mar	76.74	2%, Entry	10.42
Tata Life Science & Tech	25%	-	31-Mar	24.96	2%, Exit	10.01
Birla Equity Plan	25%	-	30-Mar	36.31	2%, Entry	6.89
Tata IT	25%	-	31-Mar	36.96	2%, Exit	6.76
Magnum Balanced	30%	1:2	17-Mar	48.14	2%, Exit	6.23
UTI Services Sector	20%	-	27-Mar	45.51	2%, Exit	4.39
Magnum Equity	22%	1:2	15-Mar	54.90	2%, Exit	4.01

Some cases for dividend stripping are:

Libra Leap is an equity fund converted into an open-end fund since February 11, 2000. Effective November '99, the HB AMC merged with Creditcapital AMC. Consequently, the fund is now managed by the merged entity, Creditcapital AMC -- manager of Taurus Mutual Fund. Entry in the fund carries a 2 per cent load, while redemption is at NAV.

The fund has declared a maiden 101 per cent dividend for all investors as on March 17, 2000. The dividend at the current entry price of Rs 49.419 will result in an instant yield of 20.25 per cent.

Birla Advantage is an aggressive equity fund. The fund carries a 2 per cent entry load. However, investment through regular investment plan or regular transfer of appreciation from its income fund is without any load.

The fund had, in August '99, declared a 20 per cent dividend. It has declared another 80 per cent dividend for all investors as on March 22, 2000. The dividend at the current entry price of Rs 78.27 will result in tax-free dividend yield of 10.22 per cent.

Kothari Pioneer Taxshield (KPTX), an open-ended equity linked tax-saving scheme, available on a no load basis has declared an 80 per cent dividend for the investors as on March 31, 2000. The fund, being a tax-planning scheme, offers a tax rebate of 20 per cent on a maximum investment of Rs 10,000.

Thus, an investment of Rs 10,000 at the current NAV levels of Rs 33.55, will not only get a tax-free dividend of Rs 2,384, but for a marginal tax-payer, a tax rebate of Rs 2,000, as well. The dividend alone will give a yield of 23.84 per cent. However, investors will have to assume the market-risk through the minimum lock-in period of three years.

Kothari Pioneer AMC has also declared a 65 per cent dividend in the dividend option of the Kothari Pioneer Bluechip Fund for investors as on March 14, 2000. Further, the AMC has also declared a 1:1 bonus in the fund. The yield in the Bluechip Fund at the current entry price of Rs 52.52 (after 2 per cent entry load) will yield a 12.38 per cent return.

However, returns on investments with a long-term perspective are much higher than the meagre returns from the short-term, speculative transactions. Further, if not for any thing else, funds discourage dividend stripping as it yields returns for the short-term investors at the cost of the long-term investors.

Funds have been generously declaring dividends so as to return to the investors as much gains as can be possible within the three years (ending financial year 2002) during which the dividends from mutual funds will be tax free. So, the best strategy is to draw dividends and simultaneously stay invested in the fund for a medium to long term.

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