Dividend Stripping

Dividend Stripping

Dividend stripping is a strategy that investors use to minimize their tax liability on mutual fund investments. It involves buying shares of a mutual fund just before the fund distributes dividends to its shareholders and selling the shares shortly after the dividend distribution. The idea behind dividend stripping is to receive the dividend payout while minimizing the tax liability that comes with it.

When a mutual fund distributes dividends to its shareholders, the payout is taxed as income. By buying shares just before the dividend distribution and selling them shortly after, investors can receive the dividend payout while reducing the amount of time they hold the shares, thereby lowering the amount of tax they have to pay. However, the government has taken measures to discourage this practice by levying a dividend distribution tax on short-term capital gains made by investors who use dividend stripping.

It’s important to note that dividend stripping is a legal but controversial tax planning strategy. It’s often used by high net worth individuals who are looking to minimize their tax liability on mutual fund investments. While it can be an effective way to lower taxes, it’s important for investors to understand the potential risks and drawbacks of this strategy. It’s also important to consult with a financial advisor or tax professional before using dividend stripping to ensure that it’s the right strategy for your individual financial situation.

Dividend stripping involves buying a security like a stock or a share or a unit of a mutual fund, which is likely to declare a dividend in the short run. When the dividend is received, the investor sells the share which will have automatically fallen in price post dividend. As a result he incurs a short-term capital loss which is available for set-off against capital gains – both short-term and long-term – as the law stands at present. The dividend itself may be exempt from tax as most dividends declared by listed companies and mutual funds are exempt under the law as it stands at present.

As an example, Mr. X buys a share at Rs 105, and that the company declares a dividend of Rs 3 (for which dividend is exempt) and the share price, post dividend, falls to Rs 102 per share. Mr. X (the assessee) achieves two benefits.

• Firstly, he receives the tax-free dividend of Rs 3
• Secondly, he has short-term capital loss of Rs 3, which can be set-off against other capital gains.

But the above route of tax avoidance is now plugged with effect from assessment year 2002-03 by virtue of the insertion of sub-section (7) in section 94 of the Income-tax Act, 1961 (“the Act”). Section 94 generally deals with the avoidance of tax by certain transactions in securities. The new sub-section (7), which was inserted by the Finance Act, 2001 with effect from assessment year 2002-03, states that where.

• Any person buys or acquires any securities or unit within a period of three months prior to the record date
• Such person sells or transfers such securities or unit within a period of three months after such date
• The dividend or income on such securities or unit received or receivable by such person is exempt, then, the loss, if any, arising to him on account of such purchase and sale of securities or unit, to the extent such loss does not exceed the amount of dividend or income received or receivable on such securities or unit, shall be ignored for the purposes of computing his income chargeable to tax.

In order to attract the provisions of sub-section (7) of section 94, all three conditions listed above are required to be satisfied. Even if one of its said conditions is not satisfied, the provisions of section 94(7) cannot be resorted to by the Department.