Shareholders and mutual fund investors often receive dividends on their investments (based on their choices). These dividends are tax-free. And if there is a long-term capital gains (LTCG), only a concessional LTCG tax 10% applies on gains above Rs 1 lakh. In addition, losses under the head ‘Capital Gains’ can be set off against income from capital gains. But some smart investors resort to ‘Dividend Stripping’ to avail maximum tax benefits. Let us try and understand the concept of dividend stripping in detail and how our tax laws keep a check on such activities.
1. What is Dividend Stripping
Investors, in a bid to avail maximum tax benefits from an investment, buy shares/mutual fund units before the declaration of dividend, post the dividend declaration they sell the share/unit when its price falls below the purchase price. This practice is termed as dividend stripping.
As a result of this activity, the investor receives tax-free dividends. But since the sale made after receiving the dividend is done at a price lower than the purchase price, it results in a capital loss. You can adjust such losses against any other capital gains income. Hence, the taxpayer enjoys a twofold benefit i.e. earning an income that is totally exempt and claiming a capital loss that can reduce the total income of the individual.
The concept of dividend stripping can be better explained by way of an example:
- Company XYZ makes an announcement that it is going to pay a dividend of Rs. 50 on April 5, 2018;
- Rahul purchased the shares of this company on March 26, 2018, when the price was Rs.180. He purchased a total of 100 shares.
- On April 5, 2018, he received a total dividend of Rs.5000.
- The price of shares after dividend declaration fell to Rs. 150. Mr A sells the shares on May 20, 2018, and therefore makes a loss of Rs.3000.
Total benefit enjoyed by Mr A is thus Rs.8000 (exempt dividend income of Rs 5,000 and capital loss of Rs 3,000)
3. Income tax implications
Dividend stripping is not exactly illegal. However, it causes a loss to the exchequer. To address this, section 94 (7) of the Income-Tax Act was introduced. Generally, those shareholders, whose name is included in the register of the company as shareholders on the record date, are entitled to receive dividends declared by the company.
The provisions of income tax on dividend stripping are applicable when an investor, who buys securities within the 3 months prior to the record date and sells such securities, within 3 months after such date in case of shares and within 9 months in case of units. In such cases, the capital loss arising to the shareholder to the extent of such dividend income shall be ignored i.e. the loss would not be available for set off against capital gain income.
- Mr A bought 1000 shares of B Co. Ltd. on Mar 2, 2018, for Rs.180/ share.
- B Co. declared a dividend of Rs.40 that will be payable on Mar 31, 2018. So he earned an income of Rs.40,000.
- On April 20, 2018, Mr A sold the shares of B Co. Ltd for Rs.120 per share. Thus he made a loss of Rs.60,000.
- The dividend income is wholly exempt in his hands.
- Of the short-term capital loss made of Rs. Rs.60,000, as per Section 94(7), Rs 40,000 would be disallowed and he can claim a loss only to the extent of Rs 20,000.
If in the above example, had Mr. A sold the shares at Rs 160, his capital loss would be lesser than the dividend received. And accordingly, no loss would be available for set off. On the other hand, if he makes a profit, his entire dividend will stand as exempted and the amount of capital gain will be subject to capital gains tax.