If you have ever wondered why SEBI renamed the dividend option in mutual funds to something called IDCW, or why certain tax planning articles from before 2020 talk about a strategy that nobody seems to use anymore, this article is for you.
The strategy they were talking about was dividend stripping. It was a way to collect a tax-free payout from a mutual fund and use the resulting NAV drop to cut your capital gains tax elsewhere. It worked well for the people who used it. The government closed it down through the Finance Act 2020. Here is how it worked and why it does not anymore.
This is the foundation of the whole strategy, so it is worth understanding clearly.
When a mutual fund declares a dividend, it pays that amount out of the fund’s own assets. The NAV drops by exactly the dividend amount on the ex-dividend date. So if a fund has a NAV of Rs 100 and declares a Rs 15 dividend, the NAV becomes Rs 85 after the payout. You receive Rs 15 in your bank account and hold units now worth Rs 85 each.
Your overall value has not changed. You just moved Rs 15 from inside the fund to your own pocket. No money was created. No returns were generated.
Here is the thing. Under the old Dividend Distribution Tax (DDT) system, that Rs 15 you received was completely tax-free. The fund house had already paid DDT to the government before distributing it. You owed nothing on it.
But the Rs 15 drop in NAV meant that if you sold your units after the dividend, you could show a capital loss of Rs 15 per unit. That loss could then be set off against capital gains you had made elsewhere, from selling stocks, a property, or anything else. Your taxable capital gain for the year went down, and so did the tax you owed.
Tax-free income in one hand, a deductible capital loss in the other. From the same transaction.
Rahul sold shares from FY 2018 to 2019 and made a short-term capital gain of Rs 2,00,000. At 15% tax, he owed Rs 30,000.
He bought 10,000 units of a mutual fund at Rs 100 per unit. Total investment: Rs 10,00,000.
The fund declared a dividend of Rs 20 per unit. Rahul received Rs 2,00,000, tax-free under the DDT rules in force at the time.
NAV fell to Rs 80. He sold all 10,000 units for Rs 8,00,000. Capital loss on the transaction: Rs 2,00,000.
He set that Rs 2,00,000 loss against his Rs 2,00,000 gain from shares. Taxable capital gain for the year: zero. Tax saved: Rs 30,000.
His portfolio was roughly where it started, but his Rs 30,000 tax liability had disappeared. For an HNI with crores of capital gains, the numbers ran proportionally larger.
In January 2016, SEBI wrote to mutual fund houses asking them to come clean on whether their schemes were being used for this.
What SEBI found was substantial. Between April 2014 and October 2015, around Rs 25,500 crore had gone into mutual fund schemes being used for dividend stripping. The paper book loses those transactions created for investors, which added up to over Rs 8,400 crore.
SEBI chief U K Sinha was direct about it. He said fund houses found facilitating dividend stripping would face regulatory consequences.
The issue SEBI had was not just the tax angle. Several fund houses were declaring high dividends, ones that were not sustainable from the fund’s actual earnings, to specifically attract this kind of money. A retail investor looking at one of these funds had no way of knowing the dividend payout rate was being inflated to serve a tax trade. They thought the fund was genuinely performing well.
The Income Tax Act had a provision targeting this strategy well before 2020. Section 94(7) says that if you buy mutual fund units within 3 months before the dividend record date and sell within 9 months after it, the capital loss cannot be claimed to the extent of the dividend received.
So you had to hold the units for at least 9 months after collecting the dividend before selling, or the loss claim was disallowed.
Investors simply factored this in. They bought, collected the dividend, held for 9 months, then sold. The market risk during those 9 months was the price they paid for the tax savings. For large enough portfolios, it was still worth it.
The Finance Act 2020, effective April 1, 2020, abolished Dividend Distribution Tax.
From that date, mutual fund dividends are treated as income from other sources under Section 56 of the Income Tax Act. They are added to the investor’s total income and taxed at the applicable slab rate. A person in the 30% bracket pays 30% on every rupee of mutual fund dividend received. If the dividend from a single fund crosses Rs 10,000 in a financial year, the fund also deducts TDS at 10% before payment.
Now run Rahul’s numbers again under the new rules.
He receives Rs 2,00,000 as a dividend. That is now taxable income at his slab rate. He records a capital loss of Rs 2,00,000 on the unit sale. The taxable income and the capital loss offset each other. Rahul has paid tax on the dividend and recovered it through the loss offset. Net result: zero. He has also taken on 9 months of market risk and paid transaction costs along the way.
Nobody banned dividend stripping. It just stopped making any financial sense.
Through SEBI Circular No. SEBI/HO/IMD/DF3/CIR/P/2020/194 dated October 5, 2020, SEBI told all mutual fund companies to rename their Dividend Option to IDCW (Income Distribution cum Capital Withdrawal) from April 1, 2021.
The word dividend was causing genuine confusion. A lot of investors, especially newer ones, assumed the payout was extra income being generated by the fund on top of their investment. In fact, when the fund pays Rs 10 per unit, the NAV drops from Rs 100 to Rs 90. The Rs 10 came from inside the fund, not from anywhere external.
IDCW spells this out. Income Distribution cum Capital Withdrawal. Some of what you receive is income earned by the fund. Some may be your own original capital being returned. The NAV drops either way.
Investors ran this strategy with company shares too, not just mutual funds. Section 94(7) covers both, though the holding periods are different.
Factor | Shares | Mutual Funds |
Buy within this many months before the record date | 3 months | 3 months |
Sell within this many months after the record date for the loss to be disallowed | 3 months | 9 months |
Dividend taxable at slab rate from April 2020 | Yes | Yes |
TDS at 10% where the dividend exceeds Rs 10,000 per year | Yes | Yes |
Any tax benefit left | No | No |
The 9-month post-sale window for mutual funds is tighter than the 3-month window for shares because fund NAVs recover more slowly after a distribution. A 3-month window would have been too easy to sidestep.
Factor | Before April 2020 | After April 2020 |
Tax on dividends received | Zero, DDT paid by the fund | Added to income, taxed at slab rate |
Capital loss from selling units post dividend | Claimable after a 9-month hold | Cancelled out by the taxable dividend income |
TDS | Not applicable | 10% where the dividend from a single fund exceeds Rs 10,000 |
Section 94(7) | Restricted the window for claiming loss | Still in force |
Option name | Dividend Option | IDCW |
Tax saving outcome | Genuine savings for HNIs | No saving possible |
Investors who need a monthly payout from their mutual fund portfolio get much better tax treatment through a Systematic Withdrawal Plan (SWP) set up on a growth plan fund.
How SWP works: you invest in a growth plan and tell the fund house to redeem a fixed amount every month. When units are redeemed, tax applies only to the capital gains component of each redemption. Not the full withdrawal amount.
Say you withdraw Rs 10,000 per month, and Rs 7,500 of that is your original principal. Only Rs 2,500 is taxed as a capital gain.
For equity funds held for more than one year, long-term capital gains up to Rs 1.25 lakh per financial year are completely exempt from tax. Gains above Rs 1.25 lakh are taxed at 12.5% without indexation. Debt fund gains are taxed at the slab rate regardless of how long you held.
An investor drawing Rs 10,000 per month through IDCW pays tax at their full slab rate on all Rs 10,000 from rupee one. The same investor drawing Rs 10,000 per month through SWP on an equity growth plan pays tax only on the gains portion, and nothing on that until total long-term gains for the year cross Rs 1.25 lakh. Same monthly income. Considerably different tax bill.
Dividend stripping worked under a tax system that made dividends free of tax in the investor’s hands. Once the Finance Act 2020 changed that, the capital loss from a dividend stripping trade simply offsets the taxable dividend income, leaving nothing to gain. SEBI had been uncomfortable with how fund houses were using dividend declarations since 2016 and completed its regulatory response with the renaming of IDCW in 2021.
For monthly income from mutual funds today, an SWP on a growth plan gets you the same regular payout with a significantly lower tax bill.
It remains as a permanent regulatory guardrail. If an investor is in a very low tax bracket (or has zero taxable income) but possesses substantial capital gains from an isolated asset sale, they could theoretically still try to use this strategy. Keeping Section 94(7) active ensures the loophole remains permanently closed for all scenarios.
No. Switching from an IDCW plan to a Growth plan is legally treated as a redemption (sale) of your existing units. This transaction will immediately trigger capital gains tax on any profit accumulated from your original purchase date up to the day of the switch.
Because you cannot predict exactly when or how much IDCW a mutual fund will declare, you are not penalized for underpaying advance tax in the quarters before the payout. However, once the IDCW hits your account, you must calculate and pay the applicable advance tax in that specific quarter’s remaining window to avoid Section 234C interest penalties.
Yes. Under the Income Tax Act, ETFs listed on Indian stock exchanges are classified as units of a mutual fund. Therefore, they are bound by the exact same rules: buying within 3 months before the record date and selling within 9 months after will trigger the loss-disallowance rule.
No. Section 94(7) only disallows your capital loss up to the exact amount of the dividend received.
Example: If you suffer a market-driven loss of ₹50 per unit, but the fund only distributed an IDCW of ₹20 per unit, your loss claim is only rejected for ₹20. You can still legally claim the remaining ₹30 as a capital loss.
No. TDS is merely an interim collection by the government, not a final tax. If you fall into the 20%, 30%, or higher tax brackets, you are legally required to pay the remaining differential tax when filing your annual Income Tax Return (ITR). Conversely, if your total income is below the taxable threshold, you can claim a refund of this TDS.
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