Dividend stripping

Dividend stripping is the purchase of shares just before a dividend is paid, and the sale of those shares after that payment, i.e. when they go ex-dividend.

This may be done either by an ordinary investor as an investment strategy, or by a company's owners or associates as a tax avoidance strategy.

Investors

For an investor dividend stripping provides dividend income, and a capital loss when the shares fall in value (in normal circumstances) on going ex-dividend. This may be profitable if the income is greater than the loss, or if the tax treatment of the two gives an advantage.

Different tax circumstances of different investors is a factor. A tax advantage available to everyone would be expected to show up in the ex-dividend price fall. But an advantage available only to a limited set of investors might not.

In any case the amount of profit on such a transaction is usually small, meaning that it may not be worthwhile after brokerage fees, the risk of holding shares overnight, the market spread, or possible slippage if the market lacks liquidity.

Tax avoidance

Dividend stripping as a tax avoidance scheme works to distribute a company's profits to its owners as a capital sum, instead of a dividend. The purpose is generally that capital gains may be subject to less tax.

As a basic example, consider a company called ProfCo wishing to distribute $X, with the help of a stripper called StripperCo.

1. StripperCo buys ProfCo shares from their present owners for $X+Y.

2. ProfCo pays a dividend of $X to StripperCo.

3. StripperCo sells its shares back to the owners for $Y.

The net effect for the owners is an $X capital gain. The net effect for StripperCo is nothing, the dividend it receives is income, and its loss on the share trading is a deduction. StripperCo might need to be in the business of share trading to get such a deduction (i.e. treating shares as merchandise instead of capital assets).

Many variations are possible:

• StripperCo might buy different "class B" shares in ProfCo for just the $X amount, not the whole of ProfCo.
• Such class B shares could have their rights changed by ProfCo, rendering them worthless, instead of StripperCo selling them back.
• ProfCo might lend money to StripperCo for the transaction, instead of the latter needing bridging finance.

The tax treatment for each party in an exercise like this will vary from country to country. The operation may well be caught at some point by tax laws, and/or provide no benefit.

Australia

In Australia, ordinary external investors are free to buy shares cum-dividend and sell them ex-dividend, and treat the dividend income and capital loss the same as for any other investment. But schemes involving a deliberate arrangement by a company's owners to avoid tax are addressed by anti-avoidance provisions of Part IVA the Income Tax Assessment Act 1936.

Investors

Dividend stripping by investors has the general advantages or disadvantages described above, but in addition in Australia there are franking credits attached to dividends under the dividend imputation system. Those credits can only be used by eligible investors (see the dividend imputation article), so there's a tension between different investors for the amount shares should fall when going ex-dividend. A rationally priced drop for one group is a bonus or trading opportunity for the other.

But the difference is not large. In a franked dividend, each $0.70 cash has $0.30 of franking attached (at the 30% company tax rate for 2005). To eligible investors it's worth $1.00, to others it's worth only $0.70 (of before-tax income in both cases). A typical half-yearly dividend (in 2005) of 2% of the share price would mean an extra 0.85% in franking credits, an amount which might easily be swamped by brokerage and the general risks noted above.

Tax avoidance

The kind of dividend stripping tax avoidance schemes described above presently fall under anti-avoidance provisions of the Income Tax Assessment Act part IVA amendments introduced in 1981.

Part IVA is a set of general anti-avoidance measures addressing schemes with a dominant purpose of creating a tax benefit. Section 177E specifically covers dividend stripping. That section exists to avoid any difficulty that might arise from identifying exactly where a tax benefit arises in dividend stripping. Dividend stripping will generally result in money to owners being taxed as dividends, irrespective of interposed steps.

Section 177E also applies to related schemes which draw off profits from a company, benefitting its owners, not just to the formal payment of a dividend. For example,

• The stripper receiving a non-recoverable loan, instead of a dividend from the target company.
• The stripper selling a worthless asset to the company.
• Owners (without a separate stripper) selling a part interest in an asset to the company, but later changing the terms to reduce its value.

Losses in the company for such related schemes may be recognised immediately in its accounts, or only booked progressively over future years, the latter being various "forward stripping" schemes. Both are caught by section 177E.

References

• Income Tax Assessment Act 1936, Part IVA (inserted 1981) [1], in particular section 177E [2]. And the explanatory memorandum [3], [4].

• Australian Taxation Office taxation ruling IT 2627 (1991) [5]

• Australian Taxation Office taxation determination TD 95/37 (1995) [6]

• Australian Taxation Office taxpayer alert TA 2004/3 (2004) [7]