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Dividend stripping generally involves purchasing a security, such as a stock or a share or a unit of a mutual fund, which is likely to declare a dividend shortly. Shortly after receiving the dividend, the person sells the share, which has automatically fallen post dividend. As a result he incurs a short-term capital loss which is available for set-off against capital gains both short-term and long-term - as the law stands at present. The dividend itself may be exempt from tax as most dividends declared by listed companies and mutual funds are exempt under the law as it stands at present. For instance, assume that a person buys a share at Rs 105, and that the company declares a dividend of Rs 3 (for which dividend is exempt) and the share price, post dividend, falls to Rs 102 per share. The assessee, in such a case, achieves two benefits. Firstly, he receives the tax-free dividend of Rs 3 and at the same time he has short-term capital loss of Rs 3, which can be set-off against other capital gains. But the above route of tax avoidance is now plugged with effect from assessment year 2002-03 by virtue of the insertion of sub-section (7) in section 94 of the Income-tax Act, 1961 (the Act). Section 94 generally deals with the avoidance of tax by certain transactions in securities. The new sub-section (7), which was inserted by the Finance Act, 2001 with effect from assessment year 2002-03, states that where (a) Any person buys or acquires any securities or unit within a period of three months prior to the record date; (b) Such person sells or transfers such securities or unit within a period of three months after such date; (c) The dividend or income on such securities or unit received or receivable by such person is exempt, 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. In order to attract the provisions of sub-section (7) of section 94, all three conditions listed above are required to be satisfied. Even if one of its said conditions is not satisfied, the provisions of section 94(7) cannot be resorted to by the Department. The term securities has been explained to include stocks and shares. And the term unit means the unit of a mutual fund specified under section 10(23D) of the Act and includes units of the Unit Trust of India. Record date has been defined as such date as may be fixed by the company or mutual fund or Unit Trust of India for the purposes of entitlement of the holder of the securities or the unit holder, to receive dividend or income, as the case may be. From the above, it will be evident that if the record date is, say, July 31, 2003, then a transaction of purchase on or after April 30, 2003 would get hit by the provisions of section 94(7) if the said purchased share or unit is
sold on or before October 31, 2003. In such an event, to the extent of dividend from the company or income distributed of the mutual fund the benefit of loss on sale will not be available. However, if the loss exceeds the extent of the dividend which is exempt from tax, then such excess loss would be available as a short-term capital loss for set-off against other capital gains and/or for carrying forward of the said loss as the case may be. When to Use Dividend Stripping: Since dividend stripping no longer can supply tax avoidance, it is less attractive than it formerly was. Even so, it can be an attractive profit option. Dividend stripping can be effective when the purchaser believes the dividend about to be paid will be higher than the loss incurred at the time of sale. On the day a company goes ex-dividend a company's share price usually falls as the cash to pay the dividend leaves the balance sheet bound for investors' pockets. In theory, this should 'all come out in the wash' as the shares should fall back by the amount paid out in dividend. But this doesn't always happen - stocks with good momentum often don't fall by the full amount.
Further medium term investments can be timed by buying just before the stock gets ex-dividend, as there is no intention to sell before three months of purchase.