Saturday, August 22, 2015

Dividend Stripping Strategy

Do you know that Dividend stripping is an investing strategy that can potentially save you a lot of money? If you invest in Mutual Funds or Stocks, understanding this strategy can be quite a handful to get that extra advantage...Read on...

 What is Dividend stripping
Dividend stripping is the purchase of shares (or mutual fund units) just before a dividend is paid, and the sale of those shares after that payment, i.e. when they go ex-dividend. On the day the company trades ex-dividend, theoretically the share price drops by the amount of the dividend. So, you are actually stripping the share value with the dividend amount - taking the dividend separately and taking a hot on the share price.

Dividing Stripping as a strategy
Dividends are usually tax free in the hands of the investor. This principle can be utilised for a smarter strategy by adopting any of the two techniques as below:

a) Though the share price dips once the share becomes ex-dividend, however, most of the quality blue chip companies, historically, recover the value of the dividend within a matter of weeks, at which time they can be sold at a potential profit.

b) For an investor dividend stripping provides dividend income, and a capital loss when the shares fall in value (in normal circumstances) on going ex-dividend. The fall in share prices can be used to book "capital loss" and adjust this capital loss against an equivalent short term capital gain of some other stock in the financial year, thus saving overall tax.

Illustration
Mr. D purchase of securities/units linked to share of a company on which dividend is payable, at a price, say Rs. 100. 
Mr. D by holding on the investment in the above securities/securities linked to share of a company enjoying the benefit of dividend distributed on such investment, say Rs. 10. 
Mr. A sells these securities/units linked to shares of a company at a lower price, say Rs. 90. 
This fall in price of the shares/units linked to share of a company by Rs. 10 is largely attributable to the dividend payout. 
This dividend stripping transaction is particularly lucrative for a taxpayer since by virtue of Section 10 (33) of the Income Tax Act, dividend distributed by a company is not taxable in the hands of its shareholders. So, the investor receives Rs. 10/- as tax free money in his / her account.
Further the taxpayer may claim a carry forward or set off of the loss arising from selling the shares/units linked to shares of a company at a lower price (Rs. 100 - Rs. 90 = Rs. 10/-). This notional Rs. 10/- loss can be adjusted against an equivalent short term capital gain of some other stock. 

Is there a counter check on this from IT Department?
Yes, there is. 
Another section 94(7) of the Income Tax Act provides that only so much of loss is available for set-off or carry forward, which exceeds the amount of dividend earned on the shares/units linked to share of a company. 
In effect, in the above mentioned example the taxpayer would have incurred a loss of Rs. 8 by virtue of sale and purchase of shares (Rs.100-Rs.92= Rs.8), however by virtue of section 94(7), he will be assumed to be actually earning a profit of Rs. 2 (Rs.8-Rs.10) So, he would have no loss for set off and carry forward purposes.

Details of Section 94(7)
As per sec. 94(7), where-
a)     Any person buys or acquires any security or unit within a period of three months prior to record date.
b)      Such person sells or transfer such securities within a period of three months after such date or transfers such mutual fund units within a period of 9 months after such record date.
c)     The dividend or income on such securities or unit received or receivable by such person is exempted.

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.

All the three conditions must be satisfied before sec. 94(7) is attracted. Thus, if the shares are acquired before the period of three months prior to record date, section 94 (7) shall not apply. Similarly, if such shares are sold after three months of the record date, section 94(7) shall not be applicable.

Summary
Dividend Stripping is not illegal, but can surely be questionable if we do not take care of provisions as mentioned Section 94(7). But as long as you are satisfying Section 94(7), you should be good to save money.
Like the article? Do not hesitate to share. It can make a positive impact on someone's life.

The book "From the Rat Race to Financial Freedom" has many such investment concepts explained in a very simple and uncomplicated manner.

Cheers

Manoj Arora
Freedom can buy you.... what money cannot !!

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