Important Keyword: Dividend Income, dividend stripping.

Dividend Stripping

Until the financial year 2019-20, investors commonly engaged in a practice known as dividend stripping to minimize taxes on capital gains and enjoy tax-free dividends. By employing dividend stripping, investors aimed to evade taxes by realizing losses to offset against capital gains, while simultaneously earning tax-free dividends. However, to curb this practice and promote fair taxation, the Finance Minister introduced Section 94(7) in the Income Tax Act during the Budget 2020 announcement.

Moreover, as a significant reform, the government abolished the Dividend Distribution Tax (DDT). Consequently, shareholders are now liable to pay taxes on dividend income received. This measure aimed to streamline the taxation system and ensure that dividends are taxed in the hands of the shareholders, aligning with the principles of equity and transparency.

What is Dividend Stripping?

Dividend Stripping is a strategy where an investor purchases shares or mutual fund units before a dividend declaration and sells them post-dividend. Here’s how it works:

1. Awareness of Dividend Declaration: The investor learns about an upcoming dividend declaration by a company.
2. Purchase of Shares/Units: Acting on this information, the investor buys shares or mutual fund units.
3. Receipt of Dividends: When the dividend is declared, the investor receives dividends on the held shares or units.
4. Sale of Shares/Units: Subsequently, the investor sells the shares or units at a reduced price post-dividend, incurring a short-term capital loss.

Benefits of Dividend Stripping:

• Tax Offset: The short-term capital loss on the sale can be offset against other capital gains, reducing the investor’s tax liability.
• Tax-Free Dividends: Dividends received are typically tax-free, providing additional benefits.

Example:

Mr. Amit learns about Company XYZ’s dividend declaration of INR 50 per share. He buys 50 shares at INR 220, investing INR 11,000. After receiving the dividend, he sells the shares at INR 150, incurring a short-term capital loss of INR 3,500. Mr. Amit benefits from tax offsets, tax-free dividends, and earns a net profit of INR 1,000.

However, to prevent tax evasion, Section 94(7) was introduced. This section disregards losses if securities are bought shortly before the dividend record date and sold shortly after. Consequently, the investor cannot use such losses to offset capital gains to the extent of the earned dividend income.

In Mr. Amit’s case, the short-term capital loss of INR 3,500 may not be eligible for tax offset against capital gains due to Section 94(7), while the dividend income of INR 2,500 would be taxable at slab rates.

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Official Income Tax Return filing website: https://incometaxindia.gov.in/