How to make your dividends tax-free

"x xx fund announced a 350 per cent dividend in its xxx equity fund." These and similar statements occur frequently in media and flaunted by mutual fund marketers in order to attract investors to invest in the fund that has just announced dividend.

As a result, many smart investors use this dividend to profit from their investment, by using dividend stripping. Let us understand what dividend stripping is all about.

Dividend stripping defined

Dividend stripping is the method in which you buy the units of the mutual fund on the announcement of the dividend and sell it as soon as you receive the dividend. Example, if a fund has announced a dividend and set the record date as December 10, you can buy the units of the funds immediately.

On 10th December, you will get the dividend and the value of the fund's units will go down accordingly. On 11th December, you can sell off the fund's units and book a loss. This will help you reduce your capital gains tax, while helping you earn tax-free income.

How does dividend stripping operate?

Assume you have earned a short term capital gain of Rs 1 lakh, which attracts a tax of 30 per cent. It means you will have to pay Rs 30,000 as tax. Now you can invest this amount in a mutual fund, whose NAV is Rs 50 and has declared a dividend of Rs 10 per unit. Now when you get the dividend, the NAV of the fund goes down to Rs 40.

Since you have suffered a loss of Rs 20,000, your actual tax liability becomes Rs 80,000. At the short-term capital gains of 30 per cent, you end up saving Rs 6000, besides earning a tax-free dividend of Rs 20,000.

Tax implications

Income tax department has wisened up to these tactics of the investors and have introduced some changes to Finance Act 2001, that deals with dividend stripping. These are the new rules affecting the dividend stripping:

• You should have purchased the units within 3 months of record date
• You should have sold them within 9 months (3 months for shares) after the record date
• The loss on the sale should not exceed the income exempted.

Currently, the case is on in Supreme Court over whether to continue with this practice.

Benefiting from dividend stripping

Dividend stripping is legal. To benefit from it, you can buy the units before the record date and then sell them within 9 months. Example, if the fund declares the record date as 15th December, ensure you sell it by 15th September.

However take into account your exemption limit. If the dividend you receive exceeds this limit, you will end up paying additional tax. While the dividend from a mutual fund is tax-free, you need to consider this point carefully in case of shares.