So, for some reason you had to sell Mutual Fund units at a lower NAV than the NAV at which you have purchased. Depending on the type of the fund and the holding period, you either realise a short-term or long-term capital loss. The Income Tax Act provides you the option to set-off capital gains (i.e. reduce the capital gains by the amount of capital loss) and carry forward the loss the successive assessment years. In this article, we will discuss the specifics of set-off and carry forwards with the limitations associated with them.
ADJUSTMENT OF LOSSES UNDER THE HEAD “CAPITAL GAINS”
Section 74 of the Income Tax Act 1961 provides the options to set-off the capital losses.
1. Short-term capital losses can be set-off against both long-term and short-term capital gain.
2. Long-term capital losses can only be set-off against long-term capital gains.
3. No capital loss can be set-off against any other head of income apart from capital gains.
4. Any capital loss which cannot be set-off can be carried forward for a maximum of eight assessment years.
“DIVIDEND STIPPING” AND RELATED LIMITATION ON SET-OFF
Consider, an investor buys unit of a dividend paying mutual fund just before the dividend distribution for Rs. 10 per unit . Now, the fund declares a dividend of Rs. 1 per unit. The NAV is expected to go down by Rs. 1.1165 (11.648% Dividend Distribution Tax with surcharge and Cess assuming equity fund). So, the NAV is now Rs. 8.8835 and he sells the units realising a capital loss of Rs. 1.1165 per unit. As per section 10(34) of the Income Tax Act dividends are not taxable in the hands of the investor. So, the investor in this case gets a tax set-off benefit without actually experiencing a loss (except to the extent of the Dividend Distribution Tax). This is called Dividend Stripping.
Section 94(7) of the Income Tax Act puts restriction on the set-off and carry forward to discourage Dividend Stripping.
According to this section, if the units are bought within 3 months of the dividend record date and sold within 9 months of the record date, the capital loss arising out of these transactions will not be eligible for set-off against other capital gains upto the amount of the dividend gained. In the above example, the amount eligible for set-off against capital loss is Rs. 0.1165 (Rs. 1.1165 capital loss– Rs. 1 dividend).
LIMIT TO SET-OFF IN CASE OF BONUS UNITS
Consider another situation where an investor bought mutual fund units at NAV Rs. 1 just before a 1:1 bonus declaration. Now, logically the NAV should reduce to Rs. 0.5. If the investor sells the units, he on paper realised a capital loss of Rs. 0.5 per unit which can be used for set-off capital gains.
The above 3 month – 9 month rule also applies here. So, this capital loss is not eligible for set-off if the units were purchased within 3 months before the bonus record date and sold within 9 months after the record date.