Arbitrage Fund Taxation – Invest In Tax-Efficient Funds

“No risks, no gains.” is a popular slogan around Dalal Street. But, if you are a risk-averse investor, you can still obtain good gains with minimal risks. One way you can achieve this is through arbitrage mutual funds.

Arbitrage means simultaneously buying and selling the same underlying security in different market segments to ensure risk-free profits. How does that work? The key point to note here is ‘different market segments.’ If the price of a security is different in different markets, you can buy it in the market where its price is low and simultaneously sell it in the market where its price is higher. Both the buy and sell transactions must occur simultaneously so that you do not expose yourself to the price movement risk.

Let us now understand how this method comes into play in mutual funds.

How do arbitrage funds work?

Most equity arbitrage funds make use of the cash-and-carry method to book profits. They buy shares of a company in the cash market and sell them in the futures market (or vice-versa), maintaining a profit position, irrespective of whether the stock price goes down or up.

For example, suppose you buy a company’s share at Rs. 2000 at the month’s beginning. But there is speculation that the share price will go up later. So, you make a futures contract of the shares, for Rs. 2040, with a maturity date of one month later. At the end of the month, the arbitrage profit is the stock price difference in the cash and futures markets.

Investors also use the same principle to earn arbitrage fund returns from the price difference of the same stock at various exchanges or indexes. However, due to the marginal profit from each sale, arbitrage schemes have to execute many trades every year to gain substantial profits. Also, to ensure maximum returns, you have to stay invested in these funds for at least three months. It helps in smoothing out daily volatilities and gives you stable arbitrage fund returns.

What are the tax benefits of arbitrage funds?

Before we get into the tax benefits, let us first have a look at the typical composition of an arbitrage mutual fund scheme:

- Equity: In arbitrage funds, equity assets like stocks, commodities, and currencies form the largest portion of the fund’s corpus. As per SEBI’s directive, arbitrage funds must invest at least 65% of their assets in equity and equity-related securities.

- High-quality debt and term deposits: Debt funds and term deposits, also called margin money, are used as collateral for the banks in the form of FDs and other assurances. 

- Liquid fund and cash: Liquid cash, which is not more than 10% of the corpus, is kept for any redemption pressures.

Due to most of the funds being invested in equity assets, SEBI recognizes arbitrage mutual funds like equity funds for tax purposes. Accordingly, the tax on capital gains from arbitrage funds is as follows:

- STCG: In the case of assets owned for less than 12 months, a short-term capital gains rate of 15% is applicable on all income from arbitrage funds.

- LTCG: If you stay invested in the fund for more than 12 months, you have to pay a long-term capital gains tax of 10% without indexation on an income of more than Rs 1 Lakh from these funds.

How does taxation work in arbitrage funds? 

It's important to understand the taxation of arbitrage funds as it can affect the overall returns. Taxes are typically calculated based on the holding period. Here's a breakdown:

- Short-Term Capital Gains (STCG): If you sell arbitrage fund units within 12 months of purchase, the gains are classified as short-term capital gains. STCG on arbitrage funds is taxed at a rate of 20%.

- Long-Term Capital Gains (LTCG): For units held for more than 12 months, the gains are classified as long-term capital gains. LTCG on arbitrage funds is taxed at a rate of 12.5%. Additionally, there is a tax exemption benefit of up to ₹1.25 lakhs per financial year. This means that if your long-term capital gains are within this limit, they are tax-free.

Who should consider investing in arbitrage funds?

Although arbitrage investments are safer than many other schemes, extreme market conditions can cause temporary losses. So, if you can hold your arbitrage positions for three to six months by blocking your funds, these schemes can then earn you profit.

You can also invest in arbitrage schemes if you are looking for the following benefits:

- Low-risk investments: Arbitrage positions ensure that you get positive returns from your investments, irrespective of the market movement. This makes it a secure asset with guaranteed returns.

- Takes advantage of volatility: An arbitrage scheme is the only mutual fund option that benefits from the volatile nature of the market. Therefore, the higher the volatility, the higher the chances of significant arbitrage fund return.

- Taxation benefits: Arbitrage schemes are taxed similarly to equity funds making it an attractive investment for people in higher tax brackets. For example, if you belong to a 30% tax bracket, investing in equity arbitrage funds can lower your tax rates to 10% for LTCG and 15% for STCG.

Frequently asked questions

1. When to use arbitrage fund?

Arbitrage funds are suitable for when you're seeking low-risk investment options with relatively stable returns. They are ideal for investors looking to park their funds for short to medium terms while aiming for tax-efficient returns.

2. Is there any risk in arbitrage funds?

While arbitrage funds are generally considered low-risk compared to pure equity investments, they are not entirely risk-free. They carry risks like market, liquidity, and interest rate risks.

3. What is the difference between an arbitrage fund and a debt fund?

Arbitrage fund focuses on leveraging price differences between the cash and derivatives markets to generate returns. On the other hand, debt funds invest primarily in fixed-income securities like bonds and government securities. They provide regular income and are less volatile.

4. Can we invest lumpsum in an arbitrage fund?

Yes, you can invest a lump sum in an arbitrage fund. These funds accept both lump-sum investments and systematic investment plans (SIPs).