Dividend stripping disallowance (Section 94(7))

Dividend stripping disallowance under Section 94(7) of the Income Tax Act 1961 is an anti-avoidance provision that prevents investors from manufacturing artificial capital losses on mutual fund units by exploiting the fall in NAV that occurs after an IDCW (Income Distribution cum Capital Withdrawal) distribution. The scheme targeted was: buy units just before the IDCW record date (at a higher pre-IDCW NAV), receive the IDCW (taxed as income), sell the units after the ex-date at a lower post-IDCW NAV (claiming a capital loss), and use the capital loss to offset capital gains elsewhere. Section 94(7) disallows the capital loss on such transactions to the extent of the IDCW received, neutralising the tax benefit.

Tax advice disclaimer. This article is for educational reference only and does not constitute professional tax or financial advice. Tax law changes frequently and individual circumstances vary widely. Readers should consult a qualified Chartered Accountant or tax adviser before making any investment or tax-filing decision.

The mechanism of dividend stripping

Before the anti-avoidance provisions, the stripping strategy worked as follows:

1. Investor A has Rs 10,00,000 of LTCG from equity shares that would be taxable.
2. Investor A buys 10,000 units of a mutual fund at NAV Rs 100 per unit (total Rs 10,00,000) just before the IDCW record date.
3. The fund distributes IDCW of Rs 10 per unit (Rs 1,00,000 total IDCW income, taxable at slab rate).
4. Ex-date NAV falls to Rs 90 (reflecting the IDCW distribution).
5. Investor A sells 10,000 units at Rs 90 each = Rs 9,00,000.
6. Capital loss = Rs 9,00,000 – Rs 10,00,000 = Rs (1,00,000).
7. This Rs 1,00,000 LTCG loss offsets the original Rs 10,00,000 LTCG, reducing tax.

The investor has received Rs 1,00,000 IDCW (taxable income) and created a Rs 1,00,000 capital loss (offsetting other capital gains). Net tax impact: IDCW is taxed at the slab rate, and the LTCG tax on Rs 1,00,000 is eliminated. Where the slab rate was lower than the LTCG rate (historically 10% LTCG vs 30% slab rate – unfavourable; but with STCG at 15%/20%, the arbitrage was meaningful for short-term gains offset).

Section 94(7) provisions

Section 94(7) provides that where:

1. Any person buys or acquires units in a mutual fund within three months before the record date (the date on which IDCW is declared);
2. The person sells or transfers the units within nine months after the record date; and
3. The dividend income on those units has been included in the total income of that person;

Then any loss arising from the sale/transfer of such units, to the extent it does not exceed the amount of the dividend income included in total income, shall not be allowed as a deduction in computing the total income.

Applicability

Section 94(7) applies to all mutual funds (equity-oriented and non-equity alike) and to all investors (individual, HUF, corporate). It does not distinguish between growth and IDCW options – if a person holds units under the IDCW option and the above conditions are satisfied, the disallowance applies.

Partial disallowance

The disallowance is only to the extent of the IDCW income. If the total loss is Rs 1,00,000 and the IDCW received is Rs 60,000, only Rs 60,000 of the loss is disallowed. The remaining Rs 40,000 of loss is allowed as a capital loss available for set-off.

Time-window analysis

The three-month pre-record and nine-month post-record windows are computed as follows:

• Three months before record date: If the record date is 15 March 2025, the pre-purchase window is 15 December 2024 to 14 March 2025. Units acquired on or after 15 December 2024 are within the window.
• Nine months after record date: Units must be sold on or before 15 December 2025 (9 months from 15 March 2025) for the disallowance to apply.

If the units are held beyond nine months after the record date before being sold, Section 94(7) does not apply.

Section 94(7) and the post-Finance Act 2020 context

Before 1 April 2020, dividends from mutual funds were exempt in the hands of the investor (Section 10(35)); Section 94(7) disallowance applied to the extent the dividend was “included in total income,” but since it was exempt, some argued the disallowance was limited. The Finance Act 2020 made dividends (IDCW) fully taxable, so from 1 April 2020, all IDCW received by an investor is included in total income and the Section 94(7) disallowance applies fully.

Interaction with Section 94(8) bonus stripping

Section 94(8) is the parallel provision for bonus units (additional units issued by the fund, analogous to a bonus issue in equities). Where bonus units are received and the original units are sold at a loss within a defined period, the loss is disallowed to the extent of the bonus unit value. Both provisions operate independently but may both apply in complex transactions.

Practical implication for IDCW option investors

Investors holding the IDCW option of equity or debt mutual funds should be aware that:

• If they switch from IDCW to growth option (a taxable switch event) within nine months of the IDCW record date, Section 94(7) may disallow the resulting capital loss.
• Short-term market downturns after IDCW distributions may create paper losses that cannot be utilised if the sale occurs within the nine-month window.
• The provision does not create a tax liability; it merely restricts the set-off of artificially manufactured losses.

See also

• Bonus stripping disallowance (Section 94(8))
• MF IDCW TDS for residents
• Equity mutual fund taxation in India
• Debt mutual fund taxation (post-April 2023)
• STCG on equity MFs (Section 111A)
• LTCG on equity MFs (Section 112A)
• MF switch as a taxable event
• Arbitrage fund taxation
• Capital gains tax in India
• ITR-2

References

1. Income Tax Act 1961, Section 94(7) – dividend stripping disallowance.
2. Finance Act 2020 – abolition of DDT and taxation of dividends in investor hands.
3. Income Tax Act 1961, Section 10(35) – repealed dividend exemption.
4. Income Tax Act 1961, Section 56(2)(i) – dividend as income from other sources.
5. Income Tax Act 1961, Section 94(8) – bonus stripping.
6. CBDT Circular on Section 94 anti-avoidance provisions.