Taxability of Dividend Stripping

What is Dividend Stripping?

Dividend stripping is a practice of buying shares or mutual fund units before the declaration of dividend, post the dividend declaration they sell the share or unit when its price falls below the purchase price. This practice is termed as dividend stripping.
The advantage for Tax Payer by doing dividend stripping is that he can avail dual Tax benefits:

  1. Dividend Income is exempt as per section 10(34/35) of Income Tax Act, 1961
  2. Loss incurred under sale of Shares can be claimed as short term capital loss.

For Example:

Mr.A buys 1000 shares of ABC Ltd. For Rs.500 per share on 25th January, dividend is declared by ABC Ltd on 19th February at Rs.100 per share. Mr. A sold those 1000 shares on 28th March for Rs.350 per Share.
In this instance, Mr. A can claim capital loss of Rs.1,50,000 and dividend earned of Rs.1,00,000 is exempt in his hands.
Due to the practice of dividend stripping the government incurs a huge loss in terms of tax revenue. Thus, to prevent the practice of dividend stripping, a new section 94(7) was introduced.

Section 94(7) of Income Tax Act, 1961

  1. Any person buys or acquires any securities or unit within a period of three months prior to the record date;
  2. Such person sells or transfers—
    • Such securities within a period of three months after such date; or
    • Such unit within a period of nine months after such date;
  3. The dividend or income on such securities or unit received or receivable by such person is exempt,

then, the loss, if any, arising to him on account of such purchase and sale of securities or unit, to the extent such loss does not exceed the amount of dividend or income received or receivable on such securities or unit, shall be ignored for the purposes of computing his income chargeable to tax.

Interpretation:

The section interprets that if an individual buys a share within 3 months prior to record date i.e. the date on which the dividend will be paid, and sell it within 3 months after the record date, then the capital loss incurred due to the sale of shares will not be allowed for set off to the extent of dividend earned.

Similarly, in case of Mutual Funds – if an individual buys unit within 3 months before the dividend is to be paid and it within 9 months, then the capital loss incurred due to the sale of mutual funds will not be allowed for set off to the extent of dividend earned.

Now, in reference to the above example given, Dividend Income of Rs.100,000 is exempt in the hands of Mr. A and Capital loss will be allowed to set off only to the extent of Rs.50,000 (1,50,000 – 1,00,000).

Tax Implications of Dividend Stripping in case of Capital Gains

In case there is a capital gain on account of sale of shares after the receipt of dividend, then the dividend amount shall be exempt and only the actual gain on sale of share shall be taxable under head “Income from Capital Gains”.

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