Dividend Stripping – Overview, Tax Implications, Example

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?

When an investor buys equity shares or units of a mutual fund knowing that the company is planning to declare a dividend and sells the shares or units after receiving the dividend, this practice is known as Dividend Stripping. Here are the stages of dividend stripping:

  • 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 benefits from bonus 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. A came to know about the news of the dividend declaration by Company XYZ of INR 60 per share. Mr. A buys 50 shares at INR 200 thus having invested INR 10,000. The Company declares and pays dividends of INR 50 per share and pays Mr. A INR 2500 (50*50).

After the declaration of the dividend, the share price drops to INR 150. Mr. A sells the 50 shares and incurs a Short Term Capital Loss (STCL) of INR 2,500.

  • STCL = 7,500 (50 shares * 150 per share) – 10,000 (50 shares * 200 per share) = -2,500
  • Dividend Income = 3,000 (50 shares * 60 per share)

Up to FY 2019-20, such dividend income was exempt from tax in the hands of the investor.

As a result of Dividend Stripping, Mr. A got the following benefits:

  • Earned Net Profit of INR 500 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 3,000 is exempt from tax under 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 taxed at 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 a period of 3 months prior to the record date of dividend declaration AND
  • The investor sells such securities within a period of 3 months or sells units within a period of 9 months after the record date of dividend declaration

Any loss incurred on the above transaction shall be ignored for the purpose of calculating capital gains. Thus, the investor will not be able to book the loss on such a sale transaction and cannot be set off against capital gains income to the extent of the dividend earned.

In the above example, Mr. A must ignore the STCL of INR 2,500 for the purpose of tax calculation. Mr. A will not be able to set off such a loss against capital gains income. Further, the income tax on dividend income of INR 3,000 would be as per slab rates.

FAQs

What is Dividend Stripping?

Dividend Stripping is a practice where the investor buys shares of a company or mutual fund units on knowing about dividend declaration, earns tax-free dividends on such shares or units, and sells them later to adjust short term capital gains (STCL) against other taxable capital gains income (STCG and LTCG). This practice is used to earn tax-free income and reduce tax liability by adjusting losses.

Is Dividend Stripping legal in India?

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.

How is Dividend Stripping different from Bonus Stripping?

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. Further, it also aims at earning long-term capital gains on selling bonus shares and paying no tax or less tax on such income.
Both Bonus Stripping and Dividend Stripping are used to evade taxes but in different ways. As per the Income Tax Act, while Section 94(7) keeps a check on dividend stripping, Section 94(8) keeps a check on bonus stripping.

Dividend Distribution Tax – DDT

What is a Dividend Distribution Tax?

Dividend Distribution Tax is the tax paid on dividends distributed by a company to its shareholders. A Domestic Company must pay DDT as per the provisions of Section 115O of the Income Tax Act. Since the Company pays DDT, the dividend income is exempt in the hands of the shareholder under Section 10(38). Under Budget 2020, the Finance Minister abolished DDT. As a result, the dividend income is now a taxable income in the hands of the shareholder. DDT would not be applicable to any dividend paid on or after 1st April 2020.

  • A Domestic Company was liable to pay DDT Tax as per Section 115O.
  • The company should pay DDT within 14 days from the date of declaring, distributing or paying the dividend whichever is the earliest.
  • If the Company does not pay dividends within 14 days, interest at a rate of 1% is payable by the Company from the date on which DDT was payable up to the date of payment of DDT to the government.

Union Budget 2021 Update

After the abolishment of DDT under Budget 2020, dividend which was earlier exempt now became a taxable income. Under Budget 2020, the finance minister introduced TDS under Section 194 and Section 194K for deduction of TDS on dividend paid on equity shares and equity mutual funds. Under Budget 2021, dividend paid to REIT / InvIT is now exempt from TDS.

Advance Tax liability would arise on dividend income only once the dividend is declared or paid since it is difficult for the shareholders to estimate the dividend income accurately.


DDT – (Dividend Distribution Tax) Rate

A Domestic Company distributing or declaring dividends should pay DDT at 15% on the gross dividend as per Section 115-O of the Income Tax Act. Since the DDT is calculated on Gross Dividend, the effective rate comes to 17.65%.

Example on DDT

A Domestic Company declares a dividend of INR 5,00,000 on 10th April 2019. Calculate DDT that Company should pay.

  1. Calculate Gross Dividend

    Gross Dividend (100%) = Net Dividend (85%) + DDT (15%)
    Gross Dividend = INR 5,00,000 * 100/85 = INR 5,88,235.29

  2. Calculate DDT on Gross Dividend

    DDT = Gross Dividend * 15%
    DDT = INR 5,88,235 * 15% = INR 88,235

Note: Thus, the effective DDT rate is 17.65%. Further, the above rate does not include cess and surcharge. After calculating cess and surcharge, the effective rate is 20.56%.

Abolishment of Dividend Distribution Tax

Under Budget 2020, the Finance Minister abolished Dividend Distribution Tax i.e. DDT. A Company is no longer liable to pay DDT. As a result, the dividend income which was earlier exempt up to INR 10 lacs, now became taxable for the investors. Such dividend income would be taxable at slab rates. Since the dividend income is taxable, TDS becomes applicable on such Income. The Finance Minister also introduced a new TDS section for TDS on dividendSection 194K (TDS on Dividend from Equity Mutual Funds) and amended the existing Section 194 (TDS on Dividend from Equity Shares).

FAQs

What is the tax treatment of dividend income from Foreign Company?

Dividend income from a foreign company is a taxable income. The investor should report it under the head Income from Other Sources. The income tax on dividend income is as per slab rates. The provisions of DDT or TDS are applicable to a Domestic Company only.

Why was the Dividend Distribution Tax (DDT) abolished under Budget 2020?

Upto FY 2019-20, a Domestic Company was liable to pay DDT at 15% on the Gross Dividend. On the other hand, Dividend was an exempt income for the shareholders.
To provide relief to the Domestic Companies and boost foreign investments, DDT was abolished under Budget 2020. Since the tax on distribution of dividend was removed, the dividend income became taxable for the shareholders. Thus, for any dividend declared or paid on or after 1st April 2020, it is taxable in the hands of the shareholder. The Company is also liable to deduct TDS as per Sec 194 or Sec 194K.

Budget 2020 : Highlights

The Finance Minister, Nirmala Sitharaman had presented the budget 2020 on the 1st of February 2020. The record-breaking 2 hours and the 30-minute speech by the Finance Minister had many major announcements. The major highlights of the budget 2020 that have been covered under this article are as follows:

New Tax Regime v/s Current Tax Regime

Income Tax Slab Rates

According to the Finance Minister, the taxpayers now have the option to either continue with the current tax regime or join the new tax regime in the upcoming Assessment Year. The major difference between both of these tax regimes is the exemptions and deductions. The given below tables shows the slab rates under both the tax regimes:

Income Range Current Income Tax Rates New Income Tax Rates
Up to INR 2,50,000 NIL NIL
INR 2,50,001 to INR 5,00,000 5% 5%
INR 5,00,001 to INR 7,50,000 20% 10%
INR 7,50,001 to INR 10,00,000 20% 15%
INR 10,00,001 to INR 12,50,000 30% 20%
INR 12,50,001 to INR 15,00,000 30% 25%
Above INR 15,00,000 30% 30%

The Finance Minister announced that under the new tax regime, the basic tax exemption limit will remain the same for all assessees including the senior citizens. Therefore, in case you opt for the new regime, there will be no higher tax exemption for the senior and super senior citizens.

Changes in Deductions and Exemptions

According to the announcement made in the budget 2020, there have been major removals of tax exemptions and deductions. This has made compliance tax less tedious. Here is the list of what deductions have stayed and what deductions have been removed:

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Changes under Income from House Property

Changes in Deductions on Home Loan interest- Section 24(b)

No claim of home loan Interest on Self Occupied House Property: Individuals who have taken a home loan on their self-occupied property and are paying interest on it, can not claim that interest deduction under Section 24(b).

A claim of home loan Interest on Rental House Property: Under the new income tax regime, individuals can claim interest on home loans for let out property only up to the amount of their rental income.

The setting off losses from house property

As per the new income tax regime, losses from house property can only be set off against other income from house property. Moreover, losses from income from house property cannot be carried forward in the new income tax regime.

Deduction for first-time Homebuyers

Deduction u/s 80EE & Section 80EEA gives relief on interest paid on home loans for first time home buyers. This deduction is no longer available for taxpayers following the new income tax regime.

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Other Important Highlights of the Budget 2020

Dividend Distribution Tax (DDT)

Dividend Distribution Tax (DDT) has been abolished for the companies. However, the dividend is now taxable for the shareholders at the rate of 15%.

Corporate Tax

Tax on co-operative societies has been reduced from 25% to 22% without exemptions. Additionally, manufacturing startups will have to pay a 15% tax if they have registered after 1 October 2019, as long as they commence operations by 31 March 2023.

Foreign Portfolio Investment (FPI)

Foreign Portfolio Investment (FPI) is an investment by non-residents in Indian securities including shares, government bonds, corporate bonds, convertible securities, infrastructure securities etc. Post budget 2020, the limit in corporate bonds has been raised from 9% to 15%.

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Residential Status

Residential status conditions have been amended in Budget 2020. 180 days in the previous financial year has been reduced to 120 days.

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FAQs

How to calculate self-occupied house property income?

​A Self Occupied House Property is the one that you use as your own residence. This property may also be used by your children, spouse and/or parents. Since there is no Income from such House Property, the gross annual value of this property is NIL (zero).

​Since the gross annual value in the case of Self Occupied House Property is zero, claiming a deduction for Home Loan interest will result in a Loss from House Property. This loss can be adjusted against income from other heads.

What are the conditions to claim deduction u/s 80EEA?

Deduction u/s 80EEA is available subject to given below conditions:

1. The stamp duty value of residential houses shall be up to Rs. 45 lakh.
2. The deduction can be claimed only by individual taxpayers.
3. The loan is taken from a financial institution.
4. The loan has been sanctioned between 01-04-2019 to 31-03-2020.
5. Assessee is not claiming any deduction under section 80EE.
6. The assessee owns no residential house property on the date of sanction of loan.

Is TDS deducted on dividend paid to a non-resident shareholder?

Yes. Domestic Company distributing dividends to a shareholder not resident in India should deduct TDS at the prescribed rates as per Section 195 of the Income Tax Act. In the case of a resident shareholder, TDS should be deducted at the rate of Sec 194 or Sec 194K.

What are the general documents needed to file ITR?

Following are the documents required to file ITR:

1. Aadhaar
2. PAN
3. Bank account details
4. TDS Certificate (Form 16, 16A, 26AS)
5. Tax payment challan (Self-assessed or Advance tax)
6. Original notice (In case of refiling the ITR)

Income from Other sources and Taxes – IFOS : Guide

What is Income from Other Sources or IFOS?

Income from Other Sources is the residual head of income. Hence, any income which is not specifically taxed under any other head of income will be taxed under this head. Further, there are certain incomes that are always taxed under this head. These incomes are as follows:

  • Dividends from companies.
  • Winnings from lotteries, crossword puzzles, races including horse races, card games, and other games of any sort, gambling or betting of any form whatsoever.
  • Income by way of interest received on compensation or on enhanced compensation shall be chargeable for tax under the head “Income from Other Sources”.
  • Gifts are also taxed under this head.
  • Family pension.
  • Different interest incomes (eg. interest income from post office savings account, bank savings account, bank fixed deposit, etc.).
  • Interest received from IT Dept. on delayed refunds.
  • Insurance commission.
  • Income from letting out of machinery, plant, or furniture.
  • Income from royalty.
  • Any sum received under a Keyman Insurance Policy including bonus.
  • Director’s commission for standing as guarantor to bankers.
  • Remuneration received by Members of Parliament.
  • Income from sub-letting of House Property by a tenant, etc.

This is an inclusive list and not an exhaustive list. Please note that Agricultural income is exempt from tax so it will not fall under any of the heads of income. It will be mentioned as exempt income while e-filing the Income Tax Return.

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In addition to the above, the following incomes are charged to tax under this head, if not taxed under the head “Profits and Gains of Business or Profession.”

  • Any contribution to a fund for the welfare of employees received by the employer.
  • Income from
    • Interest on securities.
    • Letting out or hiring of plant, machinery or furniture.
    • Letting out of plant, machinery or furniture along with building where both the lettings are inseparable.
  • Any sum received under a Keyman Insurance Policy including bonus.

Taxability of Income from Other Sources or IFOS

Taxability of incomes falling under this head may differ as per their nature. Let’s have a look at the tax treatment on some of these incomes:

Taxability of Gifts under Income from Other Sources

Gifts can mainly be classified under following categories:

  • Monetary gifts.
  • Movable properties received without consideration or without adequate consideration.
  • Immovable properties received without consideration or without adequate consideration.

Gifts will be completely taxable under the head income from other sources with the following exceptions:

  1. Some of the money received as gifts will be exempt if the aggregate value of such received during a financial year does not exceed INR 50,000.
  2. Any property received without consideration and total fair market value of such properties received throughout the year does not exceed INR 50,000.
  3. Gifts received from relatives*
    • On the occasion of the marriage.
    • Under will/by way of inheritance.
    • In contemplation of death of the payer.
    • From local authority.
    • A fund, foundation, university, other educational institution, hospitals, or any trust or institution defined in Section 10(23C).
  4. Amount received from a charitable trust registered under Section 12AA.

*Relatives for this purpose means:

1. Spouse of the individual 2. Brother or sister of the individual
3. Brother or sister of the spouse of the individual 4. Brother or sister of either of the parents of the individual
5. Any lineal ascendant or descendent of the individual 6. Any lineal ascendant or descendent of the spouse of the individual
7. Spouse of the person referred to in (b) to (f)

 

Tax Treatment of Amount received from Life Insurance Policy

Any amount received under Life Insurance policy, including any bonus amount, is exempt from tax under section 10(10D) of the Income Tax Act. A few important points to be noted with regards to this exemption:

  • Exemption is available only in respect of amount received from Life Insurance policy.
  • Exemption is available only if amount of premium paid on such policy for a particular financial year does not exceed 20% (10% in respect of policies taken on or after 1st April, 2012) of the actual capital sum assured. Please note that any amount received on death of the policyholder will continue to be exempt without any conditions.
  • While calculating the actual sum assured, any premium amount agreed to be returned or any of the benefits by way of bonus shall not be considered.

Example

Pratik has taken a Life Insurance policy on 15th December 2014. The total sum assured is INR 50,00,000 and the annual premium is INR 82,000. The policy will mature in the year 2026 and the maturity amount will be INR 10,00,000.

  • Now in the event of Pratik’s death, the amount sum assured of INR 50,00,000 received by the nominee will be completely exempt.
  • In any other case, the amount received from the policy will be exempt if the annual premium of the financial year does not exceed 10% of the capital sum assured. Here the capital sum assured is INR 50,00,000 so 10% of 50,00,000 comes to INR 5,00,000. The annual premium paid by Pratik is only INR 82,000 so nothing will be taxable if money is received in an event other than death.

Tax Treatment for Dividend Income

  • Dividend income is chargeable under this head. However, it will be completely exempt if it is received from a company that was applicable to dividend distribution tax under section 115O of the Income Tax Act.
  • This exempt dividend will be mentioned under exempt income while e-filing the Income Tax Return.
  • Dividend received from co-operative societies or foreign companies will be completely taxable.

Tax Treatment for Interest Income

Taxability of interest income may vary, depending on the nature of interest income.

  • Although Interest on the savings bank account is taxable, deduction u/s 80TTA is available for a maximum limit of INR 10,000.
  • Interest earned on tax-free bonds is completely exempt.
  • Interest on Fixed deposit and recurring deposits is completely taxable. If the total interest income from such sources exceeds INR 10,000, then the banks will deduct the TDS @ 10%. (@ 20% if the PAN is not provided).
  • Interest on Public Provident Fund (PPF) account is completely exempt.
  • Any interest earned on the post office saving bank account is exempt upto a certain extent. In case of Individual account, interest is exempt upto INR 3500 & in case of Joint account, interest is exempt upto INR 7000.
Earned Income From Other Sources
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Can I claim any expenses from Incomes from Other Sources or IFOS?

Yes, the following are some of the deductions available from income chargeable to tax under the head Income from Other Sources or IFOS:

  • Any commission or remuneration paid for realizing dividend (taxable dividend) or interest on securities.
  • Any current repairs, insurance premium, and depreciation in respect of plant, machinery, building, and furniture are deductible from the rent income earned by letting out of such plant, machinery, building, and furniture.
  • In the case of family pension, the deduction is allowed for the lower of INR 15,000 or 1/3rd of such amount received in the nature of family pension.
  • Please note that no personal expenditure shall be allowed to be deducted from income chargeable under the head ‘Income from Other Sources’.

What tax deduction cannot be claimed under Income From Other Sources?

According to section 58 of the Income Tax Act, the following are deductions that cannnot be claimed during the computation of Income from Other Sources;

  • Amount mentioned as per section 40A
  • Any personal expenses
  • Amount paid towards wealth tax
  • Expenses associated with winnings from lotteries, races, crossword puzzles, games, gambling, or betting
  • A salary that is payable outside India on which tax is not deducted at the source
  • Any interest subject to tax that is payable outside India

FAQs

Is gift taxable as other income?

Gifts from relatives are exempt and any gifts received from non relatives are exempt upto an aggregate of Rs. 50,000 in a Financial year. Total value of gifts over and above Rs. 50,000 will be taxable under the head ‘Income from Other Sources’. Gifts received on the occasion of marriage are exempt from thax. Read here to know more about Gifts and thier taxability.

Can I claim any deductions on family pension?

As per Income Tax Act, you can claim a standard deduction of 1/3rd of the amount of family pension received subject to maximum of Rs. 15,000 annually.

Is lottery prize taxable?

Yes, lottery winnings are liable to flat rate of tax at 30% without any basic exemption limit. Thus in such a case the payer of prize money will generally deduct tax at source (i.e., TDS) from the winnings and will pay you only the balance amount.