In the world of financial planning, understanding various investment strategies is key to helping individuals unlock the path to financial prosperity. Today, we delve into a strategy known as "Dividend Stripping." This practice involves astutely timing investments in anticipation of dividend declarations, ultimately reaping rewards in the form of tax benefits and increased returns. Let's explore the concept, benefits, and recent tax implications of Dividend Stripping.
Understanding Dividend Stripping
Dividend Stripping is a strategic maneuver employed by investors who possess insights into a company's plans to declare dividends. This strategy unfolds in a series of steps:
1. Awareness: The investor gains knowledge of a company's impending dividend distribution to its existing shareholders.
2. Strategic Purchase: Armed with this insight, the investor acquires equity shares or units of a mutual fund linked to the company in question.
3. Dividend Collection: As expected, the investor receives dividends on the acquired shares or units when the company distributes them.
4. Timely Sale: Post the dividend distribution, the investor strategically sells the shares or units at a reduced price, resulting in a short-term capital loss.
Benefits of Dividend Stripping for the Investor
Dividend Stripping offers several advantages for savvy investors:
- Tax Optimization: Investors can offset short-term capital losses from the sale of shares or units against other capital gains, including both short-term and long-term, thereby reducing their overall tax liability.
- Tax-Free Dividends: The investor also enjoys the perk of tax-free dividends, enhancing the overall returns on the investment.
Example of Dividend Stripping
Let's illustrate this concept with an example:
Mr. A learns of Company XYZ's plan to issue dividends at INR 60 per share. He strategically purchases 50 shares at INR 200 each, investing a total of INR 10,000. Company XYZ declares dividends of INR 50 per share, providing Mr. A with INR 2,500 (50 * 50).
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After the dividend declaration, the share price drops to INR 150. Mr. A decides to sell the 50 shares, incurring a Short-Term Capital Loss (STCL) of INR 2,500.
- STCL = INR 7,500 (50 shares INR 150 per share) - INR 10,000 (50 shares INR 200 per share) = -INR 2,500
- Dividend Income = INR 3,000 (50 shares * INR 60 per share)
Before the tax changes in FY 2019-20, such dividend income was tax-exempt for investors.
As a result of Dividend Stripping, Mr. A enjoyed:
- A net profit of INR 500 from the entire transaction.
- The ability to offset the STCL against other capital gains, both short-term and long-term.
- Tax exemption on the dividend income of INR 3,000.
However, post-Budget 2020, dividends from domestic companies became taxable, but investors can still utilize Dividend Stripping to offset losses against higher-taxed capital gains.
Section 94(7) of Income Tax Act
To curb potential tax evasion through Dividend Stripping, Section 94(7) was introduced in the Income Tax Act in Budget 2020. This section stipulates that if:
- An investor buys securities or units within 3 months before the record date of dividend declaration.
- The investor sells these securities within 3 months (or units within 9 months) after the record date of dividend declaration.
Any loss incurred in such transactions will be disregarded for capital gains calculation, preventing investors from offsetting losses against dividend income.
In our example, Mr. A would need to disregard the STCL of INR 2,500 for tax purposes and pay tax on the dividend income based on the applicable slab rates.
In conclusion, Dividend Stripping can be a lucrative strategy for investors when executed judiciously, offering both tax benefits and enhanced returns. However, recent tax changes have added complexity to this strategy, necessitating careful consideration of its implications. Always consult with a financial advisor before implementing such strategies to ensure they align with your financial goals and the prevailing tax regulations.
