What is Dividend Stripping: Its Working and Tax Implications
Mutual fund investors and shareholders, on the basis of their choices, earn dividends from their investments. Such dividends are taxable. In the case of LTCG (long-term capital gains), a 10% tax rate is imposed on the gains that exceed Rs. 1 lakh. However, some well-informed investors fall back on dividend stripping to maximise their tax benefits.
Let’s understand how dividend stripping works and how the tax policies regulate such activities. Read on!
What is Dividend Stripping?
Investors, to reap maximum possible tax benefits from their investments, purchase mutual fund units or shares before the dividend announcement date. After this dividend announcement, they sell such units/shares when their price is lower than the purchase price. Such a practice is popularly known as dividend stripping.
Through this activity, investors earn tax-free dividend income. However, as the sale proceeds involve a price below the purchase price, there arises capital loss. An individual may adjust this loss against other capital gains while filing ITR.
So, it’s a twofold advantage for taxpayers, i.e., receiving a totally tax-exempt dividend income and claiming capital losses that can decrease their total earnings. This twofold advantage is now unavailable in Finance Act 2020, and dividend income was made taxable in the hands of investors.
How Does Dividend Stripping Work?
To understand how Dividend Stripping works, let’s take an example:
Suppose, on March 7, 2019, Company ABC declared that it would pay Rs. 100 dividend per share. Rita bought this company’s shares on February 28 2019, when Rs. 200 was the price. She purchased 100 shares. On March 7 2019, she earned Rs. 10,000 (100 x Rs. 100) as dividend income.
After the dividend announcement, the share price drops to Rs. 170. Rita sold her shares on April 22 2019, and incurred a loss worth Rs. 3,000 (100 x (Rs. 200 – Rs. 170)).
Hence, Rita’s total tax benefit was Rs. (10,000 + 3,000) = Rs. 13,000, where Rs. 3,000 was a capital loss and Rs. 10,000 was tax-exempt dividend income.
Tax Implications for Dividend Stripping
The income tax provisions on dividend stripping are in force when an individual purchases shares/mutual fund units within three months before the record date but:
- Sells mutual fund units within nine months after that date
- Sells shares within three months post the record date
In this situation, an investor can ignore a capital loss incurred to the extent of a dividend, i.e., you cannot set off such a loss against other capital gains.
Example:
Let’s say that Jay purchased 100 shares of Company MN on May 2, 2019, for Rs. 200 per share. Company MN announced Rs. 50 as a dividend to be paid on May 31, 2019. Now, he received Rs. 5,000 (100 x Rs.50) as dividend income.
On June 19, 2019, Jay sold his shares for Rs. 140 per unit. Hence, he incurred a loss worth Rs. 6,000 (100 x (Rs.200 – Rs. 140)). His dividend is completely tax-exempt. As per Section 94(7), out of the loss of Rs. 6,000, he may claim short-term capital losses to the extent of Rs. 1,000 (Rs. 6,000 – Rs. 5,000).
If Jay sold his shares for Rs. 180, his dividend income would be more than his loss. Accordingly, he wouldn’t be able to set off his loss. Contrarily, if Jay earned capital gains, there would be a complete tax exemption on his dividend, and his capital gains (profits) would have been taxable.
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Things to Consider before Opting for Dividend Stripping
Keep the following things in mind before utilising dividend stripping to get tax benefits:
- It’s a disadvantage to hold the shares overnight. That’s because the share price rises or drops on the basis of market liquidity.
- You should read the background of an organisation’s dividend culture and stock. A company may release shares to raise money for running its operations. Purchasing the shares of this company may not be fruitful as the stock resale could be exhausting.
- You have to sell the stock within three months of acquisition. Check the losses applicable since the price that has dropped post the distribution date cannot return to the previous profitable amount within three months.
- Nowadays, organisations do not announce dates of dividend distribution. They informally spread the information. Track such information through credible sources and make sure the distribution date isn’t within three months. Otherwise, you may not qualify capital for loss exemption.
Final Word
An individual needs to acquire a huge capital to make dividend stripping successful. Investors who can purchase shares in bulk and have the capacity to offset risks can opt for this arrangement.
FAQs
Ans: India doesn’t consider dividend stripping illegal, but it can be threatening to some extent. This is because an investor skips tax implications and partially violates the law through this. To reduce the occurrence of this arrangement, the government introduced Section 94(7) of the Income Tax Act.
Ans: To regulate dividend stripping to some extent, Section 94(7) of the Income Tax Act proposes the following provisions:
An investor who claims short-term capital losses through the sale of shares should have acquired or bought the units within three months prior to the record date.
Such an individual should transfer or sell his/her shares within three months after the record date.
An individual should transfer or sell his/her mutual fund units within nine months after the record date.
An income or dividend from the transfer or sale of those units will be tax-exempt.
Ans: In the case of dividend stripping, short-term capital losses arise from selling shares/mutual fund units. Such losses can be set off against earnings from capital gains. If these losses do not go beyond the dividend earned, you can ignore such a dividend for calculating taxable income.
Ans: A record date signifies the date on which a firm decides which investors have qualified to earn the declared dividend payment. Investors whose names appear on a company’s record by the end of that date are eligible for such payment.
Shareholders who buy shares on this day will not earn dividends since it takes two working days for shares to be reflected in a company’s investors’ records.
Ans: Yes, an ex-dividend date is crucial as it comes prior to the record date. It denotes the date by which an individual can purchase a company’s shares to receive the upcoming dividend payment. Hence, it’s a deadline for investors who want to earn the upcoming dividend payment.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
