Fooling the taxman isn’t easy. And it’s important to understand what they already know you will do to avoid taxes, and have created laws to disallow that. Dividend stripping is one such concept.
In a strong stock market, let’s say you made a lot of “short term capital gains” by buying and selling stocks within one year. You now need to pay tax on these gains, but like normal human beings, don’t really want to.
You know that this fabulous stock is paying out a huge dividend, of about 15% of it’s market value. You pay Rs. 700 per stock, and it will pay out Rs. 100 as dividend.
The price of the stock will fall by Rs. 100 (because that’s how the market works) immediately after the dividend “record date” which is a few days away. (Companies announce dividend, and then a “record date” that is in the future)
You can buy now at Rs. 700, and sell for Rs. 600 immediately after the record date. And incur a Rs. 100 loss in the process. This Rs. 100 loss can be adjusted against your short term capital gains, to make for smaller profits and thus, save capital gains taxes.
What about the dividend? In India dividends are tax free anyhow, so you don’t pay tax on the Rs. 100 dividend.
Effectively you get a loss offset on your short term capital gains, but you don’t lose any money in reality, and thus pay lesser tax.
The tax man has figured this out too. This is called “Dividend Stripping” and the tax laws specifically address it.
Related Links:
How Can we Calculate Long Term Capital Gains Tax?
The “Loss” in such a transaction is Disallowed
There’s this section called 94 (7) of the Income Tax Act (Go here and search) which specifically addresses Dividend Stripping.
You can’t offset the Loss in the above situation if you buy and sell shares within three months of the record date.
So if you:
- Buy stock and within three months of your purchase, the dividend record date is declared
- Sell that stock within three months after the record date. (For mutual fund units, nine months after)
Then any loss in that transaction because of that dividend is not allowed. (As in, the loss must be ignored).
So if you bought at 700 and sold at 550 (market prices went even lower), and got a Rs. 100 dividend: your loss is Rs. 150, but because of the dividend, you get to record a loss of only Rs. 50.
If you sold at Rs. 650, you have a loss of Rs. 50, but since you got a dividend of Rs. 100 you have to ignore the entire loss.
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How do you legally strip dividends?
Either you buy three months before the record date, or you sell three months after the record date. Since you may not know about a record date before a dividend is declared, your purchase may only be after the declaration, which means you have to hold the stock for three months after.
You have the risk that prices will move but that’s a risk you have to take.
Related Links:
Early 2014, Coal India announced a 10% dividend! Was Dividend Stripping possible in that case?
Why is Dividend Stripping frowned upon by the Industry? A fantastic Livemint Piece
Example: Strides
Strides Arcolab will declare a dividend today (Oct 7, 2014) that is likely to be as high as Rs. 100 per share. At Rs. 700, it’s a great idea to strip dividends one thinks; but you have to hold the stock for at least three months after the record date before you sell.
In December 2013, Strides declared a dividend of Rs. 500 (the share price was Rs. 880). The price then fell to Rs. 380 and since then, has risen to Rs. 700. Holding that share would have not just paid rich dividends, it would’ve made for a brilliant capital gain too.
Disclosure: I have invested in Strides.
