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.

First, Understand What Happens When a Mutual Fund Pays a Dividend

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.

So, How Did Dividend Stripping Work?

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.

A Straight Numbers Example

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.

Why SEBI Got Involved in 2016

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.

What Section 94(7) Already Said

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 Is What Actually Ended This

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.

Why SEBI Renamed the Dividend Option to IDCW

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.

Dividend Stripping in Shares Works the Same 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.

Old Rules vs New Rules Side by Side

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

If You Want a Regular Income From Mutual Funds Today, Use SWP

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.

A Few Mistakes That Still Happen

Treating a high IDCW payout rate as a sign of good fund performance. It is not. A fund declaring Rs 8 per unit in IDCW simply has its NAV fall by Rs 8. The payout reflects a distribution decision, nothing else.
Buying into an IDCW plan just before a payout, expecting to gain from it. The NAV falls by the full payout amount on the ex date. You get Rs 10 in IDCW and end up with units worth Rs 10 less. Nothing has been gained.
Thinking the 9-month hold still makes dividend stripping work. The dividend is now taxable income. The loss and the income offset each other regardless of how long you held.
Not factoring in IDCW payouts into annual income before choosing the option. Dividends are added to total income for the financial year. A large IDCW payout can push you into a higher tax slab unexpectedly, especially if you also have salary, rental income, or interest income in the same year.

To Sum It Up Quickly

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.