Concept of Dividend Stripping and its Tax Implications

Tax implicationDo you know the concept of dividend stripping? Many people follow the practice of selling the security/ unit immediately after the record date. When a dividend is declared and received before the record date and the associated security is sold after the record date then the practice is known as dividend stripping. If you look at the whole transaction even from a lay man’s point of view, you will realize that in this transaction an investor will suffer a short term capital loss. This will happen because the ex-dividend price of the shares sold will be less than the price at which you must have purchased shares. However, as per the provisions of the income tax of India, you can set off these losses against some other short term capital gain. This will reduce your burden of tax liability.

It is mandatory for a company to maintain a register of members. Every member whose name is found in the register of members as on record date is eligible to receive dividends on the shares. In order to avoid the dividend stripping activities, Finance Act 2001 introduced section 94(7). As per the act, any short term capital loss as a result of the sale of shares will be ignored to the extent it does not exceed the income exempt under the income tax act. This rule is applicable only if the following conditions are simultaneously met. These conditions are:

  1. Shares were purchased by the seller within 3 months prior to the record date
  2. Shares were sold by the seller within 3 months after the record date (in case of units, this duration is for 9 months) and the seller has received tax free dividends

Calculation of short term capital loss and tax implications

The tax implications on short term capital losses arising out of dividend stripping activities will be dependent on the dividend income and short term capital gains of the same financial year. Let us understand the concept with the help of examples.

Let us say, that Mr. X has purchased 100 shares of Rs. 10 each of XYZ Co, amounting to Rs. 1,000 prior to 2 months of the record date and sold these shares within 3 months after the record date at Rs. 8 per share, i.e. for Rs. 800. In these dealings, he has incurred a short term capital loss of Rs. 200. And he received a dividend of Rs. 300 on these shares, which is tax free income in his hands. As per the provisions of section 94(7), as the short term capital loss of Rs. 200 does not exceed the tax exempted income of Rs. 300, he cannot set off this short term capital loss against any other short term capital gain. If his short term capital gains in the financial year stand at Rs. 400, then the entire amount will be taxable.

If in the above example, his short term capital loss would have been Rs. 400 then Rs. 100 (i.e. Rs. 400 for short term capital loss – Rs. 300 for dividend) will be eligible to be set off against the short term capital gain. Therefore, Rs. 300 (Rs. 400 for short term capital gain – Rs. 100, the amount eligible to be set off) will be taxable.

Bonus stripping activities in case of mutual funds

As there is dividend stripping activities in case of shares, in the same way there can be bonus stripping activities in case of mutual funds. The restrictive provisions of section 94(8) of the Finance Act, 2004 are applicable on mutual funds. That is, the short term capital losses arising out of selling of mutual funds cannot be set off against the short term capital gains of the same financial year if the following three conditions are simultaneously met:

  1. The original units of mutual funds were purchased within 3 months before the record date
  2. The holder (seller) of the mutual fund units have been allotted the additional or bonus units on the record date without any payment from his side, and
  3. All or part of the units is sold within 9 months after the record date and the person is still holding the bonus units.

Therefore, if the above mentioned conditions are simultaneously met, then the seller cannot set off his short term capital losses against the short term capital gains to the extent of exempted income.

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