You can put money in schemes offering high yields, take dividends and then show decline in NAV as a loss.

                                      

There is nothing in the Reliance Quant Plus Fund to attract an investor. The fund has consistently lagged its category and the benchmark Nifty in the past five years. Its past one year performance is ranked 141 out of 143 large-cap equity funds. Value Research has put it in the doghouse with a two-star rating. Yet, the scheme attracted an estimated `1,800 crore during June. The trigger: the `4.20 dividend announced by the fund. On an NAV of `14.69, the dividend yield worked out to 28%. Within days, the fund's corpus grew 5000% from `36 crore to about `1,900 crore as deep-pocketed investors poured money into the scheme to escape tax through dividend stripping.

Though dividends from mutual funds is not really a gain, HNI investors use them to reduce tax on capital gains from other investments.They put large amounts in funds that have announced big dividends just before payout date. A few days later they pocket the tax-free dividend and then show the reduction in NAV as capital loss to be adjusted against capital gains from other investments.

Dividend stripping is not illegal but certainly questionable. By paying out high dividends in obscure, underperforming schemes, fund houses are facilitating the exploitation of a legal loophole to avoid tax. The DWS Investment Opportunity Fund from Deutsche Mutual Fund has underperformed the large and mid-cap fund category and the BSE 200 index in the past five years. But the direct plan of the fund paid out `7 dividend on 25 June. On an NAV of `29.46 per unit, this works out to 24%. After the announcement, the fund's AUM jumped 150% from `120 crore in end May to over `300 crore in June.

The JM Balanced fund is another example of how the tax avoidance opportunity from dividend stripping can drive AUM. A long-time also-ran hybrid scheme, it witnessed inflows of almost `3,000 crore after its quarterly payout option declared a dividend of `4.75 per unit in June.The fund's regular dividend option paid `5.20 in January (yield 18.7%), another `8.87 in March (yield 40%) and `2.50 (yield 18.8%) in July. Anybody who invested in the fund in January got back over 60% of the investment as dividend and will be able to adjust the notional loss against other gains.

Sources say some investors are using the high dividends to transfer wealth abroad. There is a limit to how much wealth can be transfered abroad in a year. No such limit applies to dividends. So, super rich investors put money in the scheme, pocket the dividend and then move to another high dividend fund. "In 6-7 moves, a considerable amount can be turned into dividends," says an industry observer. If an investor put money in the JM Balanced fund in January and shifted to the Reliance Quant Plus Fund in April, he would have got 70% of his investment as dividends. Since the investor does not want to claim the loss, there is no compulsion to hold the fund for a minimum period.

Experts feel such tactics can prove counterproductive for the industry. If fund houses indulge in practices that facilitate tax avoidance, the government may not offer the MF industry tax concessions it seeks.

The taxman has also placed a few hurdles. The notional loss caused by the dividend payment can be claimed as loss only if the units were bought three months before the record date or are held for at least nine months after dividend payment. If the units are sold before 9 months, the loss will be disallowed under Sec 94(7) of the Income Tax Act.

This means an investor cannot use dividend stripping as a shortterm affair.If the investor wants tax adjustment benefit, he will have to remain invested for nine months.

Though this means the investor will have to carry the risk for nine months, it's a problem that can be fixed by a hedge. If one invested `12 lakh in the Reliance Quant Plus Fund in June, the value of investment after dividend of `3.4 lakh would be `8.6 lakh. To guard this against a decline in the market till March 2016, he can sell two lots of the Nifty worth `8.5 lakh in the futures market.