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An Overview of Dividend Stripping - Section 94(7)

Dividend stripping is a common strategy among investors to avoid taxes on LTCG/STCG gains or losses. Investors use this strategy to earn tax-free dividends. The government had introduced section 94 (7) of the income tax act under budget 2020 to stop dividend stripping and later DDT is also terminated. Hence shareholders are required to pay the applicable tax on Dividend income. Let’s dig out it in detail below. Read On!

What Is Dividend Stripping?

Dividend Stripping has been a common practice among investors to receive tax-exempted dividend income. In simple words, dividend stripping is when an investor buys shares or mutual funds of a company before the date of dividend declaration and sells the shares after receiving the dividend at a lower price than the actual price. Let’s have an example below to have a clear understanding of this.

Example of Dividend Stripping

Suppose, there is a company named XYZ that announces to pay a dividend of Rs. 80 on 16 August 2020. However, a person (Mohit) comes to buy the shares of this company at Rs. 200 on 28 July 2020. Now, on 16 August 2020, company XYZ issued a dividend of Rs. 80 as per the announcement to Mohit. However, after the declaration of dividends, Mr. Mohit sells the shares at Rs. September 2020 at the lower price of Rs. 140. Thus Mr. Mohit bears a loss of Rs. 60. He enjoyed a dividend Rs of .50 and a capital loss of Rs. 60. Note: The price of the shares usually decreases after the dividend are issued to the investors. The capital of Rs. 60 will be adjusted toward the dividend income and thus Rs. 10 shall be set off against the other capital gain income.

Benefits of Dividend Stripping for the Investor

Dividend stripping is a strategy that involves buying shares just before the ex-dividend date, holding them long enough to receive the dividend payment, and then selling them immediately after. The strategy is used to take advantage of the tax laws and benefit from the tax credits attached to the dividend income. However, while dividend stripping may appear to offer benefits to investors, it is generally a type of tax-avoidance strategy that is illegal in some countries. Below are some of the benefits of dividend stripping for investors- Tax savings: The main benefit of dividend stripping is the tax savings that come from claiming tax credits attached to the dividend income. In many countries, the tax rate on dividend income is lower than the tax rate on other forms of income such as wages or interest income. By buying shares just before the ex-dividend date and selling them soon after, investors can receive the dividend income and claim the associated tax credits, while avoiding the long-term capital gains tax. Increased income: Dividend stripping can also increase an investor's overall income if the dividend payout is higher than the capital gains that would be realized from holding the shares for a longer period. This can be especially beneficial for retired individuals who are looking for a steady source of income. Opportunity for reinvestment: Investors can also use the dividend income from stripping to reinvest in other assets or securities. This can help to diversify their portfolio and potentially increase their overall returns.

Section 94 (7) - Income Tax Act

Section 94 (7) of the Income Tax Act, 1961 is a provision that prevents tax evasion by taxpayers through the use of certain types of transactions. This section deals with the concept of "loss from the transfer of securities," which may happen when a taxpayer transfers securities (such as stocks, shares, or bonds) to another person at a loss, with the intention of reducing their tax liability. Under Section 94 (7), if a taxpayer sells or transfers any listed securities, and within a period of 90 days before or after the sale or transfer, the taxpayer or any person connected to the taxpayer acquires the same or similar securities, then the loss from the sale or transfer will be disregarded for the purpose of computing the taxpayer's total income. This means that if a taxpayer sells or transfers securities at a loss, but acquires similar securities within the specified time period, then the tax benefits of the loss will be denied, and the loss cannot be used to offset gains on other securities. The purpose of this provision is to prevent taxpayers from engaging in "wash sale" transactions, where they sell securities to realize a loss, only to repurchase similar securities shortly afterward. Such transactions are considered a form of tax evasion, as they enable taxpayers to reduce their tax liability without actually changing their overall investment position. It is worth noting that this section is only relevant to the listed securities, and not to unlisted securities or other assets. Additionally, the provision does not apply to losses arising from the transfer of securities in the course of a business carried on by the taxpayer.

Frequently asked questions

dividend stripping is when an investor buys shares or mutual funds of a company before the date of dividend declaration and sells the shares after receiving the dividend at a lower price than the actual price.

No. Dividend stripping illegal in India. Although section of the income tax act 1961 have formed some conditions to check dividend stripping.

Dividend stripping works by buying shares in a company just before it issues a dividend. The shareholder receives the dividend payment and then sells the shares shortly after, ideally at a similar price to what they paid for them.

Krishna Gopal Varshney

β€œKrishna Gopal Varshney co-founder & CEO of Myitronline is amongst the top emerging startups of Asia and authorized ERI by the Income Tax Department. A dedicated and tireless Expert Service Provider for the clients seeking tax filing assistance and all other essential requirements associated with Business/Professional establishment. Connect to us and let us give the Best Support to make you a Success. ”

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