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Date: January 21 2011

Dividend Stripping
Dividend stripping generally involves purchasing a security, such as a stock or a share or a unit of a mutual fund, which is likely to declare a dividend shortly. Shortly after receiving the dividend, the person sells the share, which has automatically fallen post dividend. As a result he incurs a short-term capital loss which is available for set-off against capital gains - both short-term and long-term - as the law stands at present. The dividend itself may be exempt from tax as most dividends declared by listed companies and mutual funds are exempt under the law as it stands at present. For instance, assume that a person buys a share at Rs 105, and that the company declares a dividend of Rs 3 (for which dividend is exempt) and the share price, post dividend, falls to Rs 102 per share. The assessee, in such a case, achieves two benefits. Firstly, he receives the tax-free dividend of Rs 3 and at the same time he has shortterm capital loss of Rs 3, which can be set-off against other capital gains. But the above route of tax avoidance is now plugged with effect from assessment year 2002-03 by virtue of the insertion of sub-section (7) in section 94 of the Income-tax Act, 1961 (the Act). Section 94 generally deals with the avoidance of tax by certain transactions in securities. The new sub-section (7), which was inserted by the Finance Act, 2001 with effect from assessment year 2002-03, states that where (a) Any person buys or acquires any securities or unit within a period of three months prior to the record date; (b) Such person sells or transfers such securities or unit within a period of three months after such date; (c) 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. In order to attract the provisions of sub-section (7) of section 94, all three conditions listed above are required to be satisfied. Even if one of its said conditions is not satisfied, the provisions of section 94(7) cannot be resorted to by the Department. The term securities has been explained to include stocks and shares. And the term unit means the unit of a mutual fund specified under section 10(23D) of the Act and includes units of the Unit Trust of India. Record date has been defined as such date as may be fixed by the company or mutual fund or Unit Trust of India for the purposes of entitlement of the holder of the securities or the unit holder, to receive dividend or income, as the case may be. From the above, it will be evident that if the record date is, say, July 31, 2003, then a transaction of purchase on or after April 30, 2003 would get hit by the provisions of section 94(7) if the said purchased share or unit is sold on or before October 31, 2003. In such an event, to the extent of dividend from the company or income distributed of the mutual fund the benefit of loss on sale will not be available. However, if the loss exceeds the extent of the dividend which is exempt from tax, then such excess loss would be available as a short-term capital loss for set-off against other capital gains and/or for carrying forward of the said loss as the case may be. When to Use Dividend Stripping: Since dividend stripping no longer can supply tax avoidance, it is less attractive than it formerly was. Even so, it can be an attractive profit option. Dividend stripping can be effective when the purchaser believes the dividend about to be paid will be higher than the loss incurred at the time of sale. On the day a company goes ex-dividend a company's share price usually falls as the cash to pay the dividend leaves the balance sheet bound for investors' pockets. In theory, this should 'all come out in the wash' as the shares should fall back by the amount paid out in dividend. But this doesn't always happen - stocks with good momentum often don't fall by the full amount.

Further medium term investments can be timed by buying just before the stock gets ex-dividend, as there is no intention to sell before three months of purchase.

Dividend Stripping in Mutual Funds

What was it? Dividend stripping is a strategy whereby one would save on taxes. It was a process wherein an investor would invest in a mutual fund just before the fund declared dividend and would sell the units after receiving the dividend. The mutual fund used to announce dividend in advance and investors would invest huge sums for a very small period and withdraw the amount after receiving the tax-free dividend. Buying the securities used to fetch investors dividend, and by selling it immediately a short-term capital loss was incurred. This loss was set off against a short-term capital gain, thereby reducing the tax liability. Process: For instance, a mutual fund declares an attractive dividend which is to be paid to the investors but the record date, the date when the dividend is actually going to be paid, is some days later. Seeing this as an opportunity, the high networth individual invests substantially in that fund a day before the record date. As soon as the dividend income gets credited to the investors account, the investor sells the units he bought. Now when the dividend is declared, the net asset value (NAV) of the fund also falls in proportion to the dividend declared. Therefore, his sale price becomes less than his purchase price of units. The NAV is the current market worth of a mutual fund unit which is calculated daily by taking the funds total assets less the liabilities and divided by the number of units outstanding. This leads to a short-term capital loss, which can be written off against any short-term capital gain for the year. So, he benefits by saving capital gains as well as by earning tax-free dividend income. Current scenario: However in budget 2004, the finance minister revised the tax norms under dividend stripping and marked the end of this loophole. The tax provisions now states that when a person buys any units within a period of three months before the record date, sells such units within nine months after such date (note the difference in the time period vis--vis shares), and then the dividend income on such units is exempt from tax. But the capital loss on such sale to the extent of the dividend income cannot be set off against other gains. Further, mutual funds are also now mandated to fix their record date no later than five days after they issue a public notice about the dividends. This ensures that large investors dont get a long advanced notice about an approaching dividend.