Tax planning or evasion - crossing a fine line

A recent CBDT note doesn't differentiate between planning and evasion

It is the right of every investor to plan his taxes. Tax evasion however, is a different ball game. The former is a legal exercise whereas the latter is downright illegal and will attract penalties.

However, a recent CBDT circular does not seem to differentiate between the two concepts and purports to punish those who have done some smart 'tax planning' by slapping the allegation that it could be instead 'tax evasion.'
But first, a little background.

Set off and carry forward of losses
Losses under the head capital gain, short-term or long-term, cannot be set off against income under any other head. This means, a capital loss cannot be set off against say business income or salary income; it necessarily has to be adjusted against other capital gain.

Now, from assessment year (AY) 2003-04, a long-term capital loss can be set off only against a long-term capital gain. In other words, short-term capital loss can be set off against either short-term or long-term gain but not so long-term loss.

Any unabsorbed loss may be carried forward for eight years for similar set off in the future.

Dividend stripping
Now let us see how investors could take advantage of the above mentioned rules for tax benefits.

The method of dividend stripping, extremely popular prior to 2001 (when amendments in the law were carried out to curb it) was extensively used to save tax on short-term gains.

This practice involved buying mutual fund units on or just prior to the record date for declaration of dividend, pocketing the dividend amount and selling the units at the ex-dividend NAV thereby incurring a short-term capital loss. This capital loss could be used to set off other capital gain on which tax would otherwise have been payable.

Evading Tactics
NAV at which units are purchased	Rs 25
NAV, say, after six months	Rs 28
Dividend Declared	40%
Ex-dividend NAV (Rs 28 - Rs 4)	Rs 24
Number of units purchased	1000
Purchase cost (1000xRs 25)	Rs 25,000
Dividend earned (1000xRs 4)	Rs 4,000
Sale value (1000xRs 24)	Rs 24,000
Short-term capital loss	Rs 1,000

In the example (see table), the net inflow on the investment is Rs 28,000. However, since Rs 4,000 is received in the form of dividend, investors have the opportunity to book short-term capital loss. This loss can be set off against capital gain in some other non related transaction.

The point to note here is that actually, in money terms, the investor has not incurred any loss. The loss is notional in nature, however, it could be used to adjust actual capital gain.

Enter Section 94(7)
In time, the exchequer got wise to this practice and promptly plugged it by introducing Section 94(7) w.e.f. AY 2002-03.

As per this provision, if any person buys any securities, shares or units within a period of three months prior to the record date and sells such investment within a period of three months after the record date and the dividend or income on such investment is exempt from tax, then any loss arising on account of the transaction of purchase and sale (to the extent it does not exceed the amount of dividend) shall be ignored for the purposes of computing income chargeable to tax.

In short, such loss cannot be used at all either for set off or for carry forward; it is wholly redundant. In terms of our example, the loss of Rs 1,000 would have to be ignored and hence unavailable for set off purposes.

The new circular
Now a recent CBDT circular, dated February 23, 2004, seeks to empower the Assessing Officers (AOs) to carry out an in-depth investigation to ascertain whether the motive for any transaction was to avoid payment of taxes, before disallowing any claim for tax deduction.

The moot point is whether any tax planning exercise undertaken using dividend stripping as a tool prior to the introduction of Section 94(7) is in the nature of tax evasion.

For, as per press reports, some AOs have been using Section 94(7) retrospectively disallowing claims in assessments prior to AY 2002-03, when the new provision becomes operational.

Strictly speaking, they have not been using Section 94(7) retrospectively, though the effect would be the same. The disallowance is being done taking the view that it was the investor's intention to evade tax.

Reportedly, the Commissioner (Appeals), the first appellate authority on tax matters, has held the view that shorter the period, the greater the probability that the intention was not investment.

Also, investments in funds or shares out of borrowed funds would generally support the presumption that they are not investments.

In my opinion, this is blatantly unfair. As mentioned earlier, there is a thin line between tax planning and tax evasion. However, every assessee has a right to tax planning.

Yes, at all times it would indeed be the intention of the tax payer to minimise the tax payable. As long as no law is contravened, the investor is well within his rights to use the existing framework. to minimise tax.

What about bonus issues?
Bonus offerings from mutual funds also similarly used for saving tax on short-term gains. Post the bonus issue, the NAV of the scheme would fall proportionately.

Selling the original units at the ex-bonus NAV would result in a long-term or short-term loss (depending upon the time the original units were held). In either case, these losses can be used to set off short-term gains.

The only difference between dividend stripping and this method is that in the former, the entire investment is sold off whereas in this case, the advantage lies in selling the original units only.

The bonus units would in any case have nil cost and result in capital gains. Therefore, it would make sense for investors to hold these units for 12 months and pay lower tax by converting them into long-term assets.

Incidentally, AMFI's best practices committee has discouraged members from declaring bonus ratios on existing schemes prior to the record date since it evidently helps in tax planning.

To sum
If the government feels that a loophole is being misused, it has every right to streamline the laws. However, a whimsical interpretation, that too applied retrospectively would do tremendous damage to investor confidence.

The government would have to weigh if the means justify the end. And also ask itself what kind of harm such actions would cause the so important 'feel good' factor that it has worked so hard to create.

The author may be contacted at anshanbhag@yahoo.com