All about Dividend Stripping

Dividend Stripping is applicable to
1.Securities i.e. shares & stocks
2.Units of the Mutual Fund.
Dividend Stripping simply means earning an exempt income, dividend by investing in securities and incurring a short term capital loss at the time of selling the securities or units.
How the process works?
A person buys any securities or units within 3 months prior to the record date (i.e. the date which may be fixed by company for entitlement of holders to receive dividend or unitholders to receive income)
Next he receives tax free dividend declared by the company.
Then he sells the securities within 3 months after the record date, 9 months in case of units at a loss which would be allowed as a Short Term Capital Loss.
This STCL is allowed to be set off against any short or long term capital gain or to be carried forward for future years.
When the above transactions are carried out, then the Short Term Capital Loss arising out of such transactions would not be allowed to be claimed to the extent of dividend received.
It is theoretically believed that after the dividend is paid out & shares traded for, the price of the shares falls considerably to the amount of dividend paid. This may not always be true. This concept applies only in cases where the price falls & the holder of shares incurs a loss.
This can be clearly explained with the help of an illustration
Suppose XYZ Ltd. Declares dividend on 1/4/2014, dividend payable on 1/6/2014. Mr. X buys shares on 1/3/2014 worth Rs. 1000 each. He receives dividend of Rs. 120 on each share purchased. Thereafter, on 1/8/2014 he sells those shares for Rs. 830 each.
Here, he has incurred a loss of Rs. 170 per share while he has received dividend Rs. 120 per share. Therefore, he will be allowed to claim a short term capital loss to the extent of Rs. 50 only. Loss of Rs. 120 would not be allowed as a dividend stripping transaction has taken place.
In the above case, if those share were sold for Rs. 900 each, then whole of loss would not be allowed as dividend received is Rs. 120.
Therefore, to invoke sec. 94(7), i.e. to disallow such loss all these conditions should be satisfied, i.e.
1.Shares purchased before record date i.e. cum - dividend.
2.Dividend received on record date.
3.Shares sold within 3 months after record date i.e. cum dividend.
4.Short Term Loss incurred on the said transaction.
5.2By virtue of Sec. 94(7), such short term loss would be disallowed to the extent of dividend received.
Such transactions are carried out by people for reducing the tax incidence. Therefore, next time you enter into any such transaction, beware, because Income Tax has come up to curb such transactions & your tax liability would not be reduced by virtue of this section.