Up to FY 2019-20, Dividend Stripping was a common practice amongst investors to save taxes on capital gains income and earn tax-free dividends. The investors used the practice of dividend stripping to evade taxes by booking loss for set off against capital gains income and earn tax-free dividends. Under Budget 2020, the finance minister introduced Section 94(7) in the Income Tax Act to discourage dividend stripping. Further, they also abolished DDT (Dividend Distribution Tax), and thus shareholders now need to pay tax on dividend income.
What is Dividend Stripping?
Dividend Stripping is the practice where an investor purchases equity shares or units of a mutual fund with the awareness that the company intends to declare a dividend, and subsequently sells the shares or units after receiving the dividend. Here are the stages of the same:
- Investor has news of a company set to declare dividends to existing shareholders
- Investor buys shares or mutual fund units of the said company
- Under the dividend issue, the investor receives dividends on the shares or units held
- The investor sells the shares or units at the reduced share price post-dividend and thus incurs a short-term capital loss
Benefits of Dividend Stripping for the Investor
Below are the benefits of dividend stripping for an investor:
- The investor can set off STCL on the sale of shares or units against other capital gains income, both STCG and LTCG, and thus leads to a reduction in tax liability
- The investor earns tax-free dividends
Example of Dividend Stripping
Mr. Amit came to know about the news of the dividend declaration by Company XYZ of INR 50 per share. Mr. Amit buys 50 shares at INR 220 thus having invested INR 11,000. The Company declares and pays dividends of INR 50 per share and pays Mr. Amit INR 2500 (50*50).
After the declaration of the dividend, the share price drops to INR 150. Mr. Amit sells 50 shares and incurs a Short Term Capital Loss of INR 3,500. As a result of Dividend Stripping, Mr. Amit got the following benefits
- Earned Net Profit of INR 1,000 on the entire transaction
- The STCL incurred on the sale of shares is available for set-off against other capital gains, both STCG and LTCG
- The dividend of INR 2,500 is exempt from tax under section 10(34)
- Earned profits without paying taxes
After Budget 2020, the Dividend from a domestic company became a taxable income in the hands of the investor and was taxed at a slab rate. However, in such a case, investors can still use the practice of dividend stripping for adjusting STCL with other capital gains income with higher tax rates.
Section 94(7) of Income Tax Act
To avoid the practice of tax evasion using Dividend Stripping, the finance minister introduced Section 94(7) under Budget 2020. In the same Budget, the finance minister abolished DDT (Dividend Distribution Tax) and thus it became a taxable income for the shareholders.
As per Section 94(7) of the Income Tax Act, if:
- An investor buys securities or units within 3 months before the record date of dividend declaration AND
- The investor sells such securities within 3 months or sells units within 9 months after the record date of dividend declaration
Then, any loss incurred on the above transaction shall be ignored for the purpose of calculating capital gains. Therefore, the investor cannot book the loss on such a sale transaction and cannot set it off against capital gains income to the extent of the earned dividend.
In the above example, Mr. Amit must ignore the STCL of INR 3,500 for tax calculation. Mr. Amit will not be able to set off such a loss against capital gains income. Further, the income tax on dividend income of INR 2,500 would be as per slab rates.
FAQs
A record date is the date on which a company determines the eligible investors who qualify to receive the announced dividend payment. Those investors whose names are listed on the company’s records by the conclusion of that date are entitled to receive the payment.
Dividend Stripping is not legal in India. Section 94(7) of the Income Tax Act lays down conditions to check dividend stripping in the case of equity shares and units of mutual funds in India.
Dividend Stripping is a practice of earning tax-free dividends and saving taxes by adjusting losses against capital gains income by buying shares of a company likely to announce dividends.
Bonus Stripping is a practice used for saving taxes by adjusting losses against capital gains income by selling shares of a company likely to issue bonus shares.
Hi @Utkarsh_agarwal
As a shareholder , you can expect the following benefits -
You can set off STCL on the sale of shares or units against other capital gains income, both STCG and LTCG, and thus leads to a reduction in tax liability…
You earn tax-free dividends
Hope this helps !!
@Sakshi_Shah1 can you help ?
Hi @Rishika_Reddy
As per section 94(7) of the Income Tax Act-
An investor purchases securities or units within three months of the dividend declaration record date and
After the record date of dividend declaration, the investor sells such securities within 3 months or sells units within 9 months.
Hope this help !!
Hey @HuseinContractor
If the securities or units have been bought over a period of 3 months prior to the record date, if does not satisfy the first condition laid down by Section 94(7) of the Income Tax Act.
Thus, it is not treated as Dividend Stripping and the loss would be available for set off.