Dividend Stripping in Mutual Funds: Meaning, Benefits & Implication

There are two ways a mutual fund or equity investor generates returns- capital appreciation and cash distribution like dividends.With mutual funds, investors also get the option to choose between growth and dividend schemes. The dividends are reinvested in the growth schemes while the dividend schemes pay dividends directly to the investors.A common tax-saving practice among stock and dividend-paying mutual fund investors is dividend stripping . Here’s everything you should know about what it s and how you can use it to your advantage-

Dividend stripping is the practice of investing in mutual funds or stocks just before dividend declaration. Then, after receiving the dividend, when the instrument's price is adjusted to make up for the dividend payout, the investor exits the investment.The dividend payouts are tax-free for REITs (Real Estate Investment Trusts), InvITs (Infrastructure Investment Trusts), and AIFs (Alternative Investment Funds) in India. So, the investors are not required to pay any taxes on the dividends they receive from these investments.Moreover, the losses from selling the fund units after the dividend adjustment can be claimed as a capital loss. So, the taxpayers can enjoy a twofold benefit by earning tax-free dividend income and claiming a capital loss for reducing their taxable income.

Let us assume that a mutual fund scheme announces a 20% dividend. The record date for the same is one week from the announcement. Mr Akash invests a lump sum amount in the said scheme before the record date, making him eligible to receive a 20% dividend.After receiving the dividend, the NAV of the scheme falls to adjust for the dividend payout. He then exits the investment at a loss.By doing this, Mr Akash not only received tax-free dividends, but the losses from the investment can also be set off against capital gains from investments such as shares or other mutual funds to reduce the taxable income for the financial year.

Dividend stripping is not illegal in India. However, the government incurs significant losses with this practice as it allows individuals to skip taxes to a significant extent. Thus, the government introduced Section 94(7) in the IT Act.According to Section 94(7), the taxpayers claiming capital losses from short-term investments are only eligible if-

• The investment was made within three months before the dividend record date.
• The investor exits or transfers the investment within three months after the record date or nine months in the case of mutual funds.
• The income or dividend from selling or transferring such investments is tax-free.

Any short-term capital losses arising from the sale or transfer of such shares or mutual fund units can be adjusted against other capital gains. If the capital loss is lower than the received dividend, the dividend can also be ignored while computing taxable income.

It is generally assumed that the NAV of a mutual fund or the share price will fall after dividend payments. However, it is not always the case. It is also possible for the NAV or price to rise after dividend payouts.
Whenever a company or fund house announces a dividend, it boosts investor confidence. In several cases, there is a sudden inflow of funds into such shares or mutual funds right after dividend payment. The inflow often considerably increases the share or mutual fund price, resulting in capital gains for every investor who invested before the record date.After collecting the dividend, if the fund NAV rises before the investor exits, it will provide capital gains to the investor. In such cases, the dividend received by the investor will be tax-exempt under Section 10(33). However, the capital gains on the sale will be taxable.

Budget 2022 has already introduced new amendments to prevent tax avoidance through dividend stripping. Mutual funds, REITs, InvITs, and AIFs are covered under the new amendments. But the changes will only come into effect from 2023.So, it is still possible for investors to take advantage of this tax-saving practice. If you’d like to use dividend stripping, here are a few things you should keep in mind-

• The shares should be sold within three months of purchase. The duration is nine months in the case of mutual funds. It is possible for the share or mutual fund price to witness a fall significantly higher than the dividend payout. The capital losses can be higher in such cases.
• In the case of capital gains after receiving dividends, taxes will have to be paid on the entire capital gains, except the dividend amount.
• To discourage dividend stripping , some mutual funds impose a higher exit load. Before investing, ensure that you check the same as it will impact the total returns/tax savings produced by dividend stripping.

While dividend stripping is not illegal, the government is taking multiple measures to discourage investors from using it. Moreover, you need a detailed understanding of mutual funds and tax laws to use them effectively. Any mistake in the process could result in losses or even tax penalties.So, if you’d like to use the dividend stripping practice, it’d be wise only to consider it after you thoroughly understand its functioning and legal implications. You can easily find other tax-saving investment options that can deliver higher returns and savings.An experienced investment advisor can recommend highly tax-efficient products as per your objectives to help you generate steady returns without making the investment journey increasingly complex or risky.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.