Understanding the concept of dividend stripping in India

What is dividend stripping?

Dividend stripping is an arrangement where an investor buys shares or units of mutual funds in a company before the company can declare dividends to its shareholders for the financial year. After receiving the dividend, the investor would sell the share when the market value for the share is lesser than the purchase price, which inevitably results in short-term capital loss.

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How does dividend stripping work?

For example, let us say that company ‘Z’, whose share capital is Rs. 1,00,000 distributed amongst 100 shareholders for Rs. 1,000 per share, decides to declare a dividend of Rs. 100 for every unit of share for the financial year. Knowing that the company ‘Z’ is about to issue dividends to its shareholders, an investor would buy one unit of share in the company. After acquiring the dividend, he would sell the share and retain the untaxed dividend.

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Benefits of Dividend stripping

• Income Generation: Dividend stripping allows investors to capture dividends as a source of income without necessarily holding onto the stock for a long time.
• Tax Advantage (in certain jurisdictions): Some investors might see dividend stripping as a way to avoid or minimize taxes on dividends. By quickly selling the stock after receiving the dividend, they aim to sidestep paying higher taxes on those earnings.
• Short-Term Profit Potential: If done successfully, investors may profit from the spread between the stock's buying price and the dividend received, especially if the stock price doesn't drop by the dividend amount after the ex-dividend date.

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Dividend Stripping in Income Tax Act

Under the Income Tax Act, dividend stripping refers to a practice to avoid taxes by selling company shares around the dividend declaration date. Section 94(7) of the Income Tax Act addresses the concept of dividend stripping.

Here's a simplified explanation of how dividend stripping is addressed in the Income Tax Act in India:

• Purchase before Dividend Record Date: An investor purchases shares of a company just before the record date, which is the date determined by the company for identifying the shareholders eligible to receive dividends.
• Sale after Receiving Dividend: After receiving the dividend, the investor sells the shares within a short period, often before the ex-dividend date (the date when the shares start trading without the right to receive the dividend).

Section 94(7) of the Income Tax Act aims to prevent individuals from claiming tax benefits through such transactions. It disallows the set-off of any loss arising from the transfer of shares where the transfer is followed by the acquisition of similar shares within a specified period. The objective is to prevent taxpayers from artificially creating losses and using those losses to offset taxable gains, thus reducing their overall tax liability.

The provisions in the Income Tax Act regarding dividend stripping are designed to curb the practice of using short-term transactions around dividend dates to manipulate tax liabilities. The law aims to ensure that losses from such transactions cannot be used to offset gains for tax purposes.

It's essential to note that tax laws can be intricate, and the specific application of dividend stripping provisions can vary based on individual circumstances, regulatory changes, and other factors. Therefore, seeking advice from a qualified tax professional or consultant is advisable to understand the implications and compliance requirements related to dividend stripping under the Indian Income Tax Act.

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Dividend stripping in India

Dividend stripping is not illegal in India, but such an arrangement would cause an impending loss to the state, as the individual skips tax and, to an extent, goes against the law. To curb the recurrence of dividend stripping, the Income Tax Act introduced section 94(7) has laid down some provisions that state that-

• An individual claiming short-term capital loss from the sale of a share must have purchased or acquired share units within 3 months before the record date.
• Such a person sells or transfers the securities within 3 months post the record date, 9 months in the case of mutual fund units.
• Dividend or income from the sale or transfer of such units is exempt from tax.

Loss arising from the sale of such units will be considered a short-term capital loss and can be adjusted against income. If such loss does not exceed the amount of dividend received, the dividend shall be ignored for computing income chargeable to tax.

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Dividend Stripping Example

Suppose you're interested in an Indian company, ABC Ltd., which is declaring a dividend of ₹5 per share. The ex-dividend date for ABC Ltd. is set for December 10, 2023, and the dividend payout date is December 20, 2023.

Before Ex-Dividend Date (Before December 10, 2023):

• You decide to buy 200 shares of ABC Ltd. at ₹100 per share, investing a total of ₹20,000.
• Total investment: 200 shares × ₹100 = ₹20,000

On/After Ex-Dividend Date (December 10, 2023):

• Typically, the stock price might adjust downward by the dividend amount (₹5 per share in this case) after the ex-dividend date.
• The stock price decreases to ₹95 per share post the ex-dividend date.

After Dividend Payment Date (After December 20, 2023):

• You receive the dividend payment for each share you own.
• Total dividend received: 200 shares × ₹5 = ₹1,000

Selling the Shares:

• After receiving the dividend, you decide to sell your shares.
• The stock price might still be around ₹95 per share.
• Selling 200 shares at ₹95 per share results in: 200 shares × ₹95 = ₹19,000

Overall Calculation:

• Dividend received: ₹1,000
• Sale of shares: ₹19,000
• Total received: ₹1,000 (dividend) + ₹19,000 (sale) = ₹20,000
• Initial investment: ₹20,000
• Net gain/loss: ₹20,000 (total received) - ₹20,000 (initial investment) = ₹0

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Things to look out for if you are planning for dividend stripping

These days, companies do not declare the dividend distribution dates. Although informally, they let the information out. Look out for such information through known sources and ensure the date of distribution is not within 3 months, you might not be eligible for capital loss exemption.

The shares are to be sold within 3 months of acquisition. Look out for the rate of loss as the market price has fallen after the date of distribution and wouldn’t go back to the profitable amount within 3 months.

Read the history of the company’s stock and dividend culture. The company might be releasing stock to raise investments as it might be running out of operational funds, so buying stock in such a company would be a bad decision as the resale of stock would be tedious.

One of the many disadvantages of holding the shares might be holding them overnight where the stock price tends to slide up or down based on the market liquidity.

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