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.
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.
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. 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.