Dividend Stripping – What it is and Why it is in the news

Hello Friends, you might have come across the term Dividend Stripping recently in News and articles. So I thought of writing something on what Dividend Stripping is and why it is making news. First we will start with the basic definition of Dividend Stripping,

Dividend stripping is the purchase of shares just before a dividend is paid and the sale of those shares after that payment, i.e. when they go ex-dividend (Wikipedia).

Now let us start first understand the terms used in the definition. Dividend is basically the distribution of profits by a company to its shareholders. The ex-dividend is the date on which dividend is actually allocated to the shareholders. So in simple terms buying a share before the dividend is paid and selling the share just after the dividend is paid comes under Dividend Stripping.

This example will further clarify the concept of Dividend Stripping.

Suppose there is a company named ABC with share value of 100.

I buy 500 share of this company and the ABC announces a dividend of 20 Rs.

The ex dividend date is 18-1-2016. I hold the shares till this date.

So I made a profit of 20*500 = 10,000 Rs.

On the ex-dividend I sell my entire lot of 500 shares just after the market opens at a price X.

Now let us take some cases for different values of X. The price of the share is going to fall after ex-dividend (Why? Long Concept. Cannot be taken now).

Case1: X = 90, Loss = (100-90)*500 = 5000 Rs.

Case2: X = 80, Loss = (100-80)*500 = 10,000 Rs.

Case3: X = 60, Loss = (100-70)*500 = 15,000 Rs.

I got a dividend of 10,000. So if the price of the share falls below 20 Rs per share I am going to have overall loss in the entire transaction. Then why do big investors use Dividend Stripping. They won’t go for this type of transaction until and unless there is something in it for them.

Let us understand this with a slightly different frame of mind. The dividend earned on the shares is tax free under sections 10(34) and 10(35) of the I. T. Act. So, first benefit is that I get tax free earnings from my transactions. I would reap the second benefit from the loss incurred by selling the shares. I would compensate my monetary gains from other transactions with the loss of this transaction. Let us go back to our example

We will consider case 2 for further understanding. So I had a loss of 10,000 Rs by selling the shares. I got a dividend of 10,000 Rs. So overall I had no profit no loss. Suppose before this transaction, I did two other trades with a profit of 5000 Rs in each trade. So if I did not do trading of ABC Company’s share I would have made a profit of 10,000 Rs in the complete year. This 10,000 would have been taxable income. But if I include the trade of ABC’s share I can show a loss of 10,000. So in the complete year I did not make any profit. So I need not to pay any tax for the complete year. But I got 10,000 Rs dividend which is non-taxable. Thus by Dividend stripping I saved tax on my Rs 10,000 earning. Hope this makes the concept crystal clear.

Now the main concern is “Is this legal as per our Indian IT Act?”

The answer to this question is not clear. Government wants to ends this type of tax saving and has increased the surveillance on this type of transactions. At a micro level all this would not make much difference to Government’s tax kitty. But when it comes to Big Investors and Mutual Fund houses, the difference is quite significant.

Why Dividend Stripping is in the news?

Many fund houses have started using this scheme to help out their investors in tax saving. Mutual fund schemes like DWS Investment Opportunity Fund, which is under government’s scanner for Dividend Stripping, gave out 7 Rs dividend per unit. This fund has a NAV of 29.46 per unit. So it comes out to be 24% dividend on the NAV. This is quite high for such an underperforming share. But just after the announcement of this dividend, the AUM (Assets Under Management) of DWS increased by 150% from 120 crores to 300 crores. This is not the only case. Similar data can be obtained for other fund houses also.

Some also believe the many investors are diverting money abroad using this scheme as there is no limit on how much wealth can be transferred abroad in the form of dividend. Government has introduced some laws to curb this practice. Under Sec 94(7) of the Income Tax Act, the Investor must hold the units for at least nine months after the dividend payment. Still this practice is going on and SEBI has served notice to many fund houses asking them to come out with an explanation whether they are involved in any such scheme.

I tried to explain Dividend Stripping in layman terms avoiding any technicality. You can find many articles on this in Business standard, Economic Times and other news media. For further detailed study you can refer to these news houses. If you have any doubts or any suggestions regarding this article feel free to post a comment on this. I would definitely try to improve from the suggestions you provide.

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