The Concept of Dividend Stripping in India

Investors invest in shares/units to earn returns. Returns can be earned in two ways: (i) through capital appreciation of shares/units and (ii) through dividend distributions to Investors against their holdings. 

As per the tax law, losses under the heading ‘Capital Gains’ can be set off only against income from the heading ‘Capital Gains’. Hence, some smart investors resort to ‘Dividend Stripping’ to avail themselves of maximum tax benefits. Let us understand the concept of dividend stripping in detail and how our tax laws check on such activities.

Dividend/Capital Appreciation

Dividend: Shareholders and mutual fund investors often receive dividends on their investments. Dividends are returns to investors similar to interest payments to lenders. In certain cases, these dividends are tax-free (i.e., the Company or mutual Funds pay tax in the form of Dividend Distribution Tax). 

It is also worth noting that when the dividend is declared, the price of the share/unit is corrected to the extent of the dividend declared, as this entails an outflow of funds at the Company's or mutual Funds' end.

Capital Appreciation: Dividends are direct payments to investors, whereas, in the case of capital appreciation, investors need to sell off their holdings to enjoy/encash the benefits of appreciation. Further, if there is a sale off by the Investor, it will attract long-term capital gains (LTCG), and tax on such LTCG will be at the rate of 10% on gains above Rs 1 lakh. 

What is Dividend Stripping?

Dividend Stripping is a technique whereby the Investor acquires the shares of a Company before the company declares a dividend in an attempt to earn a tax-free dividend. Once the dividend is declared by the Company and the share price corrects due to the distribution of the dividend, the Investor sells the shares to incur a short-term loss on such shares. 

Hence, the Investor gets a two-fold benefit:

1. Tax-free receipt of dividends distributed by the Company.
2. A short-term loss on sale can be used to adjust against the income from Capital Gains earned from other shares/securities/units. 

Budget 2020 Impact on Dividend Stripping 

Through Budget 2020, there has been a major overhaul in dividend taxation. Earlier, dividends were tax-free in the hands of recipients, and the Dividend Distribution Tax (DDT) was to be paid by the distributor of dividends. 

In Budget 2020, the DDT was abolished, and the tax on dividends will now be required to be paid by the dividend recipient. 

As discussed above, the concept of dividend stripping and its consequential tax implications is attracted only when the dividend is tax-free in the hands of the recipient. So, as dividends are now not tax-free in the hands of the recipient, this concept is not very relevant considering the present tax laws. 

Income Tax Implications on Dividend Stripping

Dividend stripping as a way to maximise the tax benefit is not illegal. However, it causes a loss to the exchequer. Section 94 (7) of the Income-Tax Act was introduced to address this. Generally, those shareholders whose name is included in the company's register 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 shares/units within 3 months prior to the record date and 
• sells such shares/units, 
  • In case of shares within 3 months after such record date  
  • In case of units within nine months after such record date. 

In such cases, the capital loss arising to the shareholder to the extent of dividend income earned shall be ignored, i.e., the loss would not be available to set off against other capital gains income.

Illustration

The concept of dividend stripping can be better explained by way of an example: (Assumed that dividend will be tax-free in the hands of the Investor)

• Let’s say Company X publicly announces that it will pay a dividend of Rs. 50 on April 5, 2019;  
• In anticipation of maximising the tax benefit, Mr A purchased 100 shares of Company X on March 26, 2019, at a price of Rs.180. 
• On April 5, 2019, he received a total dividend of Rs.5000.
• The price of shares fell to Rs. 130 after April 5, 2019. Mr. A sold the shares on May 20, 2019, and therefore made a loss of Rs.5000 on such sale.

Based on the above illustration, it can be understood that the total benefit enjoyed by Mr A is Rs.10000 (exempt dividend income of Rs 5,000 and a capital loss of Rs 5,000, which can be used to adjust against the other capital gains income)

Hence, as per Section 94(7), a short-term capital loss of Rs. 5,000 would be disallowed, and he cannot claim a loss.