In India, taxation of arbitrage funds helps investors immensely. The Arbitrage funds are treated in part with equity funds for taxation purposes. That is, if you hold the funds for less than a year, you pay 15% short-term capital gains (STCG) tax. But if held for more than a year, then you only pay 10% long-term capital gains (LTCG) tax on amounts exceeding Rs 1 lakh a year.
And this is why arbitrage funds are liked by a lot of large investors who belong to the higher tax slabs of 20% and 30%. If you compare the taxation of arbitrage funds with debt funds, then for a period below 3 years, the gains in debt funds are taxed at 20% or 30% depending on the slab of the investor.
Here is a brief refresher about what is an Arbitrage fund?
Arbitrage Fund belongs to a special category of mutual funds, i.e. Hybrid Funds. These funds work on the principle of profiting from arbitrage opportunities in two different markets. In this case, cash and the derivative segment of the equity markets. The fund needs to hold at least 65% in equities (including derivatives) in order to qualify as equity funds for tax purposes. So even though these are hybrid funds, these are treated as equity funds for taxation purposes. And that is what makes them attractive.
Many times, these funds are looked at as – Arbitrage funds good alternatives to liquid funds.
As mentioned earlier, it’s not the pre-tax returns that win it for arbitrage funds. Rather it’s the post-tax returns.
Here is how the gains from Arbitrage Funds are taxed:
- Short Term Capital Gains (STCG) – If gains are made in arbitrage funds held for less than 1 years (or 12 months), then it is taxed at 15%
- Long Term Capital Gains (LTCG) – If gains are made in arbitrage funds held for more than 1 year (or 12 months), then it is taxed at 10% for gains above Rs 1 lakh a year.
Arbitrage funds can be more tax-efficient than liquid funds based on your tax bracket. If you are in the 20-30% tax slab, then the average returns of both categories suggest that arbitrage funds deliver superior post-tax returns for periods above 1-2 years.
Let’s say the 1-year pre-tax return for both the arbitrage fund and a comparable debt fund is 7%. Now assuming a period slightly higher than 1 year, the applicable tax rate in the case of arbitrage fund will be 10%, hence the post-tax returns will be 6.3%. But in the case of liquid funds, the applicable tax rate will be as per the slab of the investor. So in the case of the 5% tax slab, the post-tax returns will be 6.65%. In the case of the 20% slab, it will be 5.6% and in the case of the 30% slab, it will be 4.9% (please ignore cess for simplicity).
So for higher tax slabs, arbitrage funds deliver better post-tax returns.
But even though arbitrage funds are tax-friendly, they are still volatile. And hence, may not be suitable for everyone and those who want to invest for the very short term. I would say that if you have to invest in arbitrage funds, you should be willing to stick around for 1 or more years. Anything less and it may not work in your favor when compared to other debt fund categories like liquid funds, ultra-short duration funds, money market funds, etc.
So that is about the Taxation of Arbitrage Funds (2021) in India.