Tax Implications of Dividend Stripping (with Examples)

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Dividend stripping is the practice of buying a share/mutual fund units, just before the declaration of dividend and then selling it off right after the receipt of dividend, when the share prices fall below the purchase price.

This practice is done for tax saving purposes, as the dividend received is exempt in the hands of the shareholders and the loss incurred on the sale of shares can be claimed as a capital loss.

Let’s understand it better with the help of an example,

Example of Dividend Stripping

Mr. A is interested in buying a share of XYZ company whose price as on 25th February is Rs. 200. This company has announced that it will pay dividend of Rs. 40 to its shareholders on 31st March.

So, Mr. A here buys 1000 shares of XYZ company at Rs. 200 each. And then on 31st March he received the dividend of Rs. 40,000 (i.e. Rs. 40/ share for 1000 shares).

On 5th April, the share price of the company falls to Rs. 160. Mr. A then sells the 1000 shares bought by him at Rs. 150 and incurs a loss of Rs. 50 per share, which is Rs. 50,000. He claims this loss as a short term capital loss in his tax return to save tax against other short term capital gain.

And the dividend earned on the shares, Rs. 40,000, is exempt in the hands of the investor by the tax law.

By doing this, Mr. A has not only earned a tax-free profit of Rs. 40,000 on the dividend income but also booked a loss of Rs. 50,000 on which he can set-off his other short term capital gain and hence saved tax on it.

This practice of buying and selling shares to book tax free profits and avoid taxes is called dividend stripping.

Due, to the practice of dividend stripping the government incurs a huge loss in terms of tax revenue. Thus, to prevent the practice of dividend stripping, a new section 94(7) was introduced.

Is Dividend Stripping legal?

Yes, Dividend Stripping is legal. However, if you are planning to take some tax benefits by doing Dividend Stripping, then you would not be able to claim these benefits because of Section 94(7).

As per section 94(7), where-

a. Any person buys or acquires any security or unit within a period of three months prior to record date;

b. Such person sells or transfers
i. Such securities with in a period of three months after such date, or
ii. Transfers such units within a period of 9 months after such date;

c) 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.

Interpretation:

So this section states that if you buy a share within 3 months prior to the record date i.e. the date on which the dividend will be paid, and sell it within 3 months after the record date, then the capital loss incurred due to the sale of shares will not be allowed for set off to the extent of dividend earned.

Similarly, In case of Mutual Funds – if you buy a mutual fund 3 months before the dividend is to be paid and sell it within 9 months, then the capital loss incurred due to the sale of mutual funds will not be allowed for set off to the extent of dividend earned.

DIVIDEND STRIPPING

Let’s understand this better with an example,

Mr. A bought the 1000 shares of XYZ at Rs. 200 on 2nd February. XYZ declared a dividend of Rs. 40 on each share payable on 31st March.

He got the dividend of Rs. 40,000 on his 1000 shares on 31st March.

After that on 5 July he sold the shares for Rs. 150 each. He incurred a loss of Rs. 50 on each share, making a total loss of Rs. 50,000.

Now here, since Mr. A bought the shares just one month before the record date, section 94(7) shall apply to him,

Thus, the dividend income of Rs. 40,000 will become tax-free in his hands under section 10(33) which exempts the dividend income in the hands of the shareholder but he will not be able to book the entire capital loss of Rs. 50,000.

The short term capital loss of Rs. 50,000 will be adjusted with the dividend income earned of Rs. 40,000. Hence, he can only claim the difference which is Rs. 10,000 (50,000-40,000) as his short term capital loss.

In the same case, if Mr. A had bought the shares on 31st October, he could book the entire loss of Rs. 50,000 under short term capital loss, since the shares were purchased 3 months prior to the the record date which is 31st March and sold after 3 months which is 3rd July.

Refer to the table given below for a better understanding of the various cases,

Particulars Case I Case II Case III Case IV
Dividend 31st March 31st March 31st March 31st March
Dividend Amount 40,000 40,000 40,000 40,000
Purchase Date 25th February
(1 Month prior to record date)
31st October
(5 months prior to record date)
25th February
(1 Month prior to record date)
31st October
(5 months prior to record date)
Purchase Price 200,000 200,000 200,000 200,000
Sale Date 5th August
(3 months after the record date)
5th April
(within 3 months after the record date)
5th April
(within 3 months after the record date)
5th August
(3 months after the record date)
Sale Price 150,000 150,000 150,000 150,000
Capital Loss 50,000 50,000 50,000 50,000
Loss Allowed/Not Allowed Loss disallowed to the extent of dividend earned Loss disallowed to the extent of dividend earned Loss disallowed to the extent of dividend earned Complete loss allowed
Allowed Loss 50,000-40,000= 10,000 50,000-40,000= 10,000 50,000-40,000= 10,000 50,000

 

All the above cases are where there is a loss on account of sale of shares. Since section 94(7) states about the treatment of capital loss in case of dividend stripping. Let’s see what is the taxability if there is a gain on account of sale of shares.

Tax implications of Dividend Stripping in case of Capital Gains

In case there is a capital gain on account of sale of shares after the receipt of dividend, then the dividend amount shall be exempt and only the actual gain on sale of share shall be taxable under the head “Income from Capital Gains”.

Let’s understand this better with an example,

Mr. A is interested in buying a share of XYZ company whose price as on 25th February is Rs. 200. This company has announced that it will pay dividend of Rs. 40 to its shareholders on 31st March.

Mr. A buys 1000 shares of XYZ company at Rs. 200 each. And then on 31st March he receives a dividend of Rs. 40,000 (i.e. Rs. 40/ share for 1000 shares).

On 5th April, the share price of the company rises to Rs. 230. Mr. A then sells the 1000 shares bought by him for Rs. 200 at the rate of Rs. 230 per share and earns a profit of Rs. 30 per share, which is Rs. 30,000.

In this case, the dividend of Rs. 40,000 earned by him shall be exempt under section 10(33) and the capital gain amount of Rs. 30,000 shall be taxable under the head “Income from Capital Gains”. The entire Rs.70,000 of profit shall not become taxable, only the gain amount will be taxable.

Karan is CA by Qualification with the rare distinction of being awarded All India Rank 22. He is also the founder of this website and is an expert in helping people save Taxes legally. He can be reached by booking an appointment for Tax Advisory Service.