Section 94(7): How the Income Tax Act deals with dividend stripping
Section 94(7) of the Income Tax Act is a tax rule that targets dividend stripping and stops investors from claiming artificial capital losses just to save tax. This blog explains dividend stripping, how Section 94(7) works, and why it still matters for smart tax planning.
What is dividend stripping?
Dividend stripping is a strategy where an investor buys shares or mutual fund units just before the dividend date, collects the dividend, and then sells them soon afterward, usually at a lower price.
If the price usually falls by roughly the amount of the dividend, the investor ends up with:
Dividend income, and
A capital loss on sale.
When dividends were tax‑free in the investor’s hands (before Budget 2020), this was giving a double tax benefit to such investors. It was tax‑exempt dividend income plus a capital loss that could be set off against other taxable capital gains.
Why did the government introduce section 94(7)?
The government noticed that some investors were not doing this for genuine investment reasons, but simply to create paper losses and reduce their tax liability.
Section 94(7) was introduced to stop this tax arbitrage. Its purpose is to ensure that if a loss arises mainly because of a dividend‑stripping transaction around the record date, that loss cannot be fully used to save tax.
What is section 94(7) of the income tax act?
Section 94(7) of the Income Tax Act, 1961 is an anti‑avoidance provision that specifically deals with dividend stripping in shares, securities and mutual fund units.
If you buy securities/units just before the record date, receive tax‑exempt dividend or income on them, and then sell them within a short period after the record date, the capital loss on such sale will be ignored (disallowed) to the extent of the exempt income received.
Key conditions under section 94(7)
Section 94(7) applies only if all the following conditions are satisfied at the same time:
Purchase Timing
You acquire the securities or units within 3 months before the record date for dividend/income.
Sale Timing
You sell or transfer:
Shares/securities: within 3 months after the record date.
Mutual fund units: within 9 months after the record date.
Exempt Income
The dividend or income received on such securities/units is exempt from tax in your hands.
If even one of these conditions is not met, Section 94(7) does not apply.
Time limits specified under section 94(7)
For quick reference, the time windows under Section 94(7) are:
Buying of shares/securities: Within 3 months before the record date.
Sale of shares/securities: Within 3 months after the record date.
Sale of mutual fund units: Within 9 months after the record date.
These windows are short so that only timing based, dividend driven trades are targeted, not long-term investments.
How section 94(7) disallows capital loss
When Section 94(7) gets triggered, the capital loss on the sale of securities/units is partly or fully ignored. The logic is:
The loss is disallowed up to the amount of exempt dividend/income you received.
Only the excess loss, if any, can be claimed as a normal capital loss.
Take simple numbers example & assume the dividend is exempt from tax.
Dividend stripping example under section 94(7)
Case 1: Loss greater than dividend
You buy units for ₹30,000.
You receive exempt dividend of ₹5,000.
You later sell the units for ₹24,000.
Loss = ₹30,000 − ₹24,000 = ₹6,000
Exempt dividend = ₹5,000
Under Section 94(7):
Allowed loss = ₹6,000 − ₹5,000 = ₹1,000
Disallowed loss = ₹5,000 (equal to the dividend)
So, you don’t get full loss of ₹6,000, but you only get ₹1,000 because you already enjoyed ₹5,000 tax‑free.
Case 2: Loss less than or equal to dividend
You buy for ₹30,000.
You receive exempt dividend of ₹5,000.
You sell for ₹27,000.
Loss = ₹30,000 − ₹27,000 = ₹3,000
Exempt dividend = ₹5,000
Here, loss (₹3,000) < dividend (₹5,000), so the entire ₹3,000 loss is disallowed.
Applicability of section 94(7) to mutual funds
Section 94(7) clearly covers units of mutual funds, not just shares. The only difference is in the sale window:
For shares/securities: sale within 3 months after the record date.
For mutual fund units: sale within 9 months after the record date.
This longer window for units is designed to capture structured dividend‑stripping strategies using mutual funds, where investors might hold slightly longer but still primarily for tax‑driven dividend and loss booking.
Does section 94(7) apply to all investors?
Yes. Section 94(7) is not restricted to any specific category of taxpayer. It can apply to:
Individuals (including retail investors)
HUFs
Firms and LLPs
Companies
Any other taxable person
What matters is the nature and timing of the transaction, not who you are. If the conditions are met, the rule applies.
Dividend stripping vs bonus stripping
Dividend stripping and bonus stripping are related tax‑arbitrage strategies but are dealt with by two different sub‑sections.
Dividend stripping (section 94(7))
You buy before the dividend record date.
You receive dividend.
Price falls ex‑dividend & you sell and book a loss.
Section 94(7) disallows loss to the extent of exempt dividend.
Bonus stripping (section 94(8))
You buy units before a bonus issue.
You receive bonus units.
The value shifts between original and bonus units.
You sell the original units at a loss while retaining the bonus units.
Section 94(8) restricts such losses.
Both provisions have the same philosophy: stop investors from creating artificial capital losses around corporate actions (dividends or bonus issues) to reduce tax.
Impact of section 94(7) on tax planning
After the abolition of Dividend Distribution Tax (DDT) in Budget 2020, most dividends are now taxable in the hands of investors at their applicable slab rates. That changes how often Section 94(7) gets triggered:
For normal equity shares and many mutual funds, dividends are no longer exempt, so the crucial exempt‑income condition usually fails.
This has made Section 94(7) less relevant for standard dividend scenarios, but it has not become redundant.
Section 94(7) still matters & where:
Section 94(7) still matters in situations where investors receive exempt income on units or securities and try timing‑based buy‑and‑sell trades around record dates to create capital losses.
After the law was widened, this can technically include certain units of business trusts (like REITs/InvITs) or AIFs where specific distributions are structured as exempt under the Act, so investors should check whether the income is exempt before relying on any loss for tax purposes
From a tax‑planning perspective:
You should avoid entering and exiting positions purely around record dates where income is exempt.
It’s safer to base decisions on investment merit, not on short‑term dividend‑driven tax plays.
Always check whether the income you are receiving is taxable or exempt before considering any such strategy.
Section 94(7) of the Income Tax Act is a focused rule that prevents investors from abusing dividend stripping that is, earning exempt dividends and simultaneously creating artificial capital losses. Even though dividends are now usually taxed for investors, this rule still matters in cases where some payouts are tax‑free. It acts as a safety check to stop people from misusing those exempt incomes to create fake tax losses.
For retail investors, understanding Section 94(7) helps avoid aggressive tax tactics that may later be disallowed and ensures more compliant, predictable tax outcomes.
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FAQ
Section 94(7) applies when:
You buy shares or units within 3 months before the record date,
You sell shares within 3 months after, or mutual fund units within 9 months after, the record date, and
The dividend or income you received on them is exempt from tax.
All three conditions must be satisfied together.