What is dividend stripping? How can we book a capital loss through dividend stripping? How can an investor avail of the benefits?
—Atanu Saha & Sachin Chauhan
Dividend stripping refers to using dividends declared by a mutual fund to lower one's tax liability. Here's how it works. If you expect a mutual fund to declare a dividend soon, you can buy its units before the record date.
When the fund declares a dividend, the NAV will go down, and that is the amount you will receive as dividend. And when the record date for dividend payment is over, you can sell these units. What you end up with is a capital loss and a dividend. Since dividend paid by equity funds is tax free as compared to 10 per cent you pay on short-term capital gains, the tax liability stands reduced.
Here's a detailed illustration of how this works. Suppose you have a short-term capital gain of Rs 2 lakh during the current year and if you don't do any tax planning, you would pay approximately Rs 20,000 as tax. Alternatively, you could invest half of the amount, which amounts to Rs 1 lakh, in an equity oriented mutual fund that has an NAV of Rs 10, and declares a dividend of 50 per cent. This means that for each unit, investors receive Rs 5 as dividend and the NAV goes down to Rs 5. For your Rs 1-lakh investment, you get Rs 50,000 as dividend. However, on the capital account, your investment of Rs 1 lakh is now reduced to Rs 50,000--a loss of Rs 50,000.
Let us see how this affects an individual's tax liability. The amount of capital loss that you suffered in the second transaction will now reduce your original short-term capital gain of Rs 2 lakh to Rs 1.5 lakh. The tax liability on this amount will be Rs 15,000. Dividends from equity mutual funds being tax-free would not attract any tax. Thus, your total tax liability is down from Rs 20,000 to Rs 15,000--a saving of 25 per cent.
Budget 2004, though, has curbed the benefits of dividend stripping. Under the revised laws, it has been provided that if an investor were to acquire a unit within a period of three months from the record date and sell or transfer the same within a period of nine months from the record date, then any loss arising from the transaction shall be ignored to the extent that the loss does not exceed the amount of such dividend. Earlier, if the investors bought the units three months prior to the record date, and sells or transfers the units three months after the record date, then the loss would be ignored to the extent that the loss does not exceed such dividend.