What's Dividend Stripping?

What is dividend stripping? Is it legal? Can I use it to save tax?

Dividends can be used to lower your tax liability. The proportion of tax you can save though is lower than it used to be previously and now comes with a caveat. Nevertheless the method is still useful. Let us explain how it works. Suppose 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 taxed only at 10 per cent (till March 31, 2003)—far lower than the 30 per cent you are likely to pay otherwise—the entire exercise will reduce your tax liability.

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 60,000 as tax. Alternatively, you could invest this sum in a fund that has an NAV of Rs 20, 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 15. For your Rs 2-lakh investment, you get Rs 50,000 as dividend. However, on the capital account, your investment of Rs 2 lakh is now reduced to Rs 1.5 lakh—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 45,000. In addition, you will have to pay a 10 per cent tax on the Rs 50,000 you received as dividend. Thus, your total tax liability is down from Rs 60,000 to Rs 50,000—a healthy saving of 16.67 per cent.

Of course, there are some flies in the ointment. You obviously will be exposed to some market risk since this exercise involves an equity fund—a dividend from a debt fund is taxed normally according to your income slab (till March 31, 2003). You also pay an entry and exit load that the transaction requires. Over and above that, you need to have a fair knowledge about funds' dividend declarations so that you can time your transaction. However, Budget 2002 tried to plug dividend stripping. It introduced a clause, which said that in order to offset any capital gain against any capital loss (owing to a fall in the NAV due to dividend declaration), an investor will have to stay invested for at least three months.

So, is dividend stripping legal? Yes it is. It may be an unintended consequence of the way the government has made tax laws, but it is not illegal. Since it is unintended, laws may be changed in the future to make it less rewarding. And this is what Budget 2003-04 did. This year's Budget proposes to make dividends from mutual funds tax-free in the hands of investors. As dividend stripping only works when the dividends are subject to tax, dividend stripping will no longer be viable post-March 31, 2003.