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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 could 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.

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, company 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.

Benefits of Dividend stripping

In this arrangement, the investor receives benefits of,

  • Setting off the short-term capital loss in income tax returns
  • Tax-free dividend

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 which 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 person sells or transfers the securities within 3 months post the record date, 9 months in 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 as 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.

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

  • These days, companies do not declare the dividend distributions 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, else you might not be eligible for capital loss exemption.
  • The shares are to be sold within 3 months of acquisitions. 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 the shares overnight. Where the stock price tends to slide up or down based on the market liquidity.