What was it?
Dividend stripping was a strategy whereby one would save on taxes. It was a process wherein an investor would invest in a mutual fund just before the fund declared dividend and would sell the units after receiving the dividend. The mutual fund used to announce dividend in advance and investors would invest huge sums for a very small period and withdraw the amount after receiving the tax-free dividend.
Buying the securities used to fetch investors dividend, and by selling it immediately a short-term capital loss was incurred. This loss was set off against a short-term capital gain, thereby reducing the tax liability.
For instance, a mutual fund declares an attractive dividend which is to be paid to the investors but the record date, the date when the dividend is actually going to be paid, is some days later. Seeing this as an opportunity, the high networth individual invests substantially in that fund a day before the record date. As soon as the dividend income gets credited to the investors account, the investor sells the units he bought. Now when the dividend is declared, the net asset value (NAV) of the fund also falls in proportion to the dividend declared. Therefore, his sale price becomes less than his purchase price of units. The NAV is the current market worth of a mutual fund unit which is calculated daily by taking the fund’s total assets less the liabilities and divided by the number of units outstanding. This leads to a short-term capital loss which can be written off against any short-term capital gain for the year. So, he benefits by saving capital gains as well as by earning tax-free dividend income.
However in budget 2004, the finance minister revised the tax norms under dividend stripping and marked the end of this loophole. The tax provisions now states that when a person buys any units within a period of three months before the record date, sells such units within nine months after such date, and then the dividend income on such units is exempt from tax. But the capital loss on such sale to the extent of the dividend income cannot be set off against other gains. Further, mutual funds are also now mandated to fix their record date no later than five days after they issue a public notice about the dividends. This ensures that large investors don’t get a long advanced notice about an approaching dividend.