SLATE. All you wanted to know about dividend stripping

Recently, market regulator SEBI asked mutual fund houses to disclose if they had been helping investors practise dividend stripping, to escape taxes. It noted that about ₹25,000 crore in short-term money was allegedly collected by some schemes between April 2014 and October 2015, to help investors milk the tax break on dividends. Smells like a scam? Maybe, but dividend stripping investors usually operate well within the letter of the law (if not the spirit).

When companies announce dividends, all investors holding the share on a specified date (record date) are eligible to receive it. Once the dividend is paid, the stock goes ex-divided and begins to trade at a lower price. If you happen to buy the share just ahead of the record date and sell it just after it goes ex-dividend, you pocket tax-free dividend. You can also book (fictional) short-term capital ‘losses’ on your stock. You can then ‘set off’ this loss against other profits you made to claim a tax exemption. This is dividend stripping.

In recent times, though, dividend stripping has been used mostly in mutual funds. Investors get information about a fund’s dividend payout in advance and buy its units in advance. Once the dividend is announced, they collect it and also book a capital ‘loss’ as the fund’s Net Asset Value (NAV) dips due to the payout. These losses are then used to claim tax breaks.

In order to discourage dividend stripping, in 2004, dividend payout rules were tweaked by the tax department. The new rules specified that an investor can claim a notional loss on NAV due to dividends, only if the units were purchased three months before the record date or were held for at least nine months after the dividend is paid.

Dividend stripping is not illegal. But it goes against the spirit of the law which makes deliberately avoiding taxes a crime. Short-term flows that flood in and out of mutual funds also go against the grain of mutual fund investing, as the scheme gets used as a short-term arbitrage vehicle, rather than the long-term investment it is meant to be. Such short-term flows hurt the interests of genuine long-term investors in a fund. Needless to say, it also dents the government’s tax kitty. One estimate placed the notional losses from mutual fund dividend stripping at ₹8,400 crore.

As it is actually illegal to share ‘tips’ about a company’s or fund’s upcoming dividends in advance, you should resist the temptation to indulge in dividend stripping if you are a stock or fund investor. If you never intended to invest in a scheme and are doing so only for the dividend tax break, you could make a real loss due to market fluctuations in the holding period. If you aren’t a dividend stripper, but are a long-term investor in a fund, don’t mistake a scheme’s swelling assets for runaway popularity. It could just be the dividend at play.

If your wealth manager recommends such an opportunity, you can come out ahead by saying no. There is typically a deluge of money into such schemes which will also drain in a hurry. The exit may also happen when the market may not be favourable. These could leave you to grapple with real losses.

Stripping may be a good idea if you’re keen to catch the sun or dive into the pool. But do it on tax matters and it may leave you exposed.

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