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Shareholders and mutual fund investors, besides the returns they receive on the investments made, enjoy certain tax benefits too. First and foremost, the dividend they receive is tax-free. Further, the capital gains made, if long-term, are subject to a concessional tax rate of 10% provided the gains are above Rs 1 lakh. In addition, losses under the head capital gains can be set off against income from capital gains.

However, smart investors indulge in an activity known as ‘Dividend Stripping’ and accordingly avail maximum tax benefits. Let us try and understand the concept of dividend stripping in detail and also see if the tax law of India has its own checks on the activity of Dividend Stripping.

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, on the one hand, receives dividend income which is tax-free. On the other hand, since the sale made after receiving the dividend is done at a price lower than the purchase price, it results in a capital loss. Such a loss can be adjusted 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, and thereby decrease the tax liability.

2. Illustration

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 as such is not 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.

Example:

  • 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 example mentioned above  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 charged to tax under capital gains.

 

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