Understanding Dividend Stripping in Mutual Funds…

Dividend stripping was a common strategy for mutual fund investors, especially the large corporate and HNI investors. However, post the regulatory changes a few years ago, the utility of dividend stripping has become substantially limited. However, it is still practiced where the investors are willing to hold for a slightly longer period. Here is how dividend stripping works in case of mutual funds.

Understanding dividend stripping…

We are all aware that dividends declared by mutual funds are entirely exempt from tax in the hands of the mutual fund investors. This creates a unique arbitrage opportunity for the mutual fund investors. If you buy mutual fund units just before the dividend record date and sell off the units after the record date, then there is a unique tax arbitrage available. The loss on the sale of the mutual fund units can be set off against the capital gains available from other sources. This enables the investor to reduce his tax liability substantially without any additional investment or lock-in requirement. Let us understand this mechanism of dividend stripping with a practical example.

How dividend stripping works in practice…

Let us assume that an investor Rohit Shah has purchased mutual funds worth Rs.200,000/- (10,000 units at NAV of Rs.20/- each). 10 days after the purchase was the dividend record date where the fund declared a dividend of Rs.2 per unit. Thus Rohit Shah received a tax-free dividend of Rs.20,000/- from his mutual fund holdings. Typically, the mutual fund NAV adjusts downward to the extent of the dividend declared after the record date. Thus the NAV of the fund goes down to Rs.18/- after the record date. If Rohit Shah sells his units after the record date, then he books a loss of Rs.20,000/- {10,000 units X (20-18)}.

Let us also assume that Rohit Shah has a short term capital gain from sale of shares to the extent of Rs.30,000/-. Now he can write off his loss on mutual funds of Rs.20,000/- and reduce his short term capital gains from equities to just Rs.10,000/-. He effectively saves 30% of Rs.20,000 (Rs.6,000) as tax. Why is this called dividend stripping? The loss on mutual funds is notional because the Rs.20,000 has already been stripped out of the fund in the form of tax-free dividends. This is a double benefit for the investor as he received tax-free dividend as well as reduces his overall tax liability.

Tax authorities have substantially curbed this practice…

The Union Budget in 2004 introduced a new proviso that this facility of write-off will only be permitted if the mutual fund units are held for a minimum period of 3 months prior to the dividend record date or 9 months post the record date. This has substantially reduced the interest in dividend stripping. Of late, SEBI has been investigating cases where investors had invested huge monies with prior knowledge of the dividend record dates. SEBI and the Income Tax department have been keen to curb this practice as it gives an unfair advantage to certain investors and also because it takes away a chunk of the tax revenues of the government.

Is the dividend strategy still workable?

It is still possible by legitimately estimating the likely dividend date range. Typically, funds tend to declare their dividends around a certain period and hence it is possible to approximately estimate their record dates and invest 3-4 months prior to that. It is a very legitimate and simple way of reducing your tax liability, although it will involve locking in your funds for a short period of time. Hence the opportunity cost of these funds vis-a-vis the tax benefits will have to be evaluated before taking a dividend stripping decision.

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