What is Dividend Stripping & how does it work? Dividend Stripping is a strategy to reduce the tax liability under the preview of tax law. It refers to the activity of buying and selling of securities or units within before/after time of record date of dividend paid. It is applicable mainly in direct equities and mutual funds.
Income Tax guidelines for Dividend Stripping For Direct Equity: Section 94(7) of the Income Tax Act says that 3 conditions should satisfy while exercising dividend stripping option to avoid the tax. 1. The Purchase has been made within three month before the record date of dividend. 2. The Sell should have been made within the three month after the dividend record date. 3. The losses on the sale should not exceed the dividend income exempted.
Dividend Declared Buying Shares
Within 3 Months
Within 3 Months
For Mutual Fund Units: Section 94(7) of the Income Tax Act says that 3 conditions should satisfy while exercising dividend stripping option to avoid the tax. 1. The Purchase has been made within three months before the record date of dividend. 2. The Sell should have been made within the nine months after the dividend record date. 3. The losses on the sale should not exceed the dividend income exempted. Dividend Declared Buying MF units
Within 3 Months
Selling MF units
Within 9 Months
CENTRE Example: Let us understand the above technicality with a simple example. Say, if you have invested in mutual fund dividend option on 1st July, 2011 of Rs. 1,00,000 with NAV Rs. 50 (you get 2,000 units in total). On 25th August, 2011 this gives dividend of 20% i.e. Rs. 10 per unit, meanwhile the NAV at which it was purchased was increased to Rs. 55. As you know, whenever dividend is declared the NAV also goes down to the extent of dividend price. Here your actual NAV i.e. Rs. 55 will go down by Rs. 10 to Rs. 45. So if you sell the complete units you will incur a capital loss of Rs. 10,000 [(2,000 x Rs. 50)-(2,000 x Rs. 45)]. So this loss amount of Rs. 10,000 can be set of against your other short term gains from mutual funds within the same financial year. For investors in shares, Dividend Stripping provides dividend income and a capital loss when the shares fall in value on going ex-dividend (A security becomes ex-dividend on the ex-dividend date, which is usually two business days before the record date set by the company issuing the dividend). This may be profitable if the income is greater than the loss, or if the tax treatment of the two gives an advantage.
Summary of the above 1. Dividend stripping refers to timing the purchase and sale of shares/MF units to reduce tax liability. You can avail of the set-off benefits available on short-term capital loss arising from the transaction. 2. Dividends bring down the share price to the extent of the payout. By buying shares when they are cum-dividend and selling when they become ex-dividend, you make a short-term capital loss. 3. This short-term capital loss can be set-off against short-term as well as long-term capital gains made in other transactions during the current year. 4. Unabsorbed short-term capital loss can be carried forward for up to eight years. Also, the dividend received by the investor is exempt from tax. 5. Section 94(7) of the IT Act disallows set-off benefits on any short-term capital loss if the shares were acquired within three months before the record date or sold within three months after the record date. 6. In case of mutual funds, the effectiveness of Dividend Stripping depends on the dividend distribution tax applicable on debt fund dividends. It also depends on the exit loads at the time of redeeming the units.
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