Dividend Stripping in Mutual Funds

Dividend stripping exploited the mechanical NAV reduction that follows every IDCW (Income Distribution cum Capital Withdrawal) payout. When a mutual fund declares a dividend of Rs 5 per unit, the NAV falls by exactly Rs 5 (minus applicable taxes) on the ex-dividend date. A sophisticated investor could purchase units before the record date, receive the dividend income, and then sell the units at the lower post-dividend NAV, booking a capital loss. That capital loss could be set off against other capital gains, effectively creating a tax shield.

Prior to its closure, the strategy was particularly attractive when dividends from debt mutual funds were taxed at lower rates than regular income, or when the investor's overall capital gains tax burden was high. The mechanics created a scenario where the investor received economic neutrality (the dividend approximately offset the NAV fall) but achieved a tax benefit through the capital loss claim — an outcome that was fiscally cost-free but treasury-depleting.

Section 94(7) of the Income Tax Act, 1961 was enacted to block this practice. Under Section 94(7), if an investor: (a) purchases mutual fund units within three months before the record date for dividend, and (b) sells or transfers those units within nine months after the record date, then the capital loss arising on such sale, to the extent of the dividend income received, shall not be allowed as a deduction. The disallowed loss is not permanently extinguished — it is instead treated as the cost of acquisition of new units acquired in the future, effectively deferring (rather than destroying) the tax benefit.

The practical impact of Section 94(7) is that the dividend stripping window is closed for most retail investors. Institutional investors who hold units for longer than nine months may still technically receive the dividend before a price correction, but the economic arbitrage largely disappears over longer holding periods as NAV recovery occurs. The provision applies to both equity and debt scheme dividends.

With the abolition of the dividend distribution tax (DDT) in Budget 2020, dividends from mutual funds became directly taxable in the hands of investors at their applicable slab rates, further reducing the appeal of dividend stripping. Post-2020, the entire rationale of accessing dividends at a concessional tax rate evaporated for most taxpayers, making Section 94(7) a provision with declining practical relevance.