Arbitrage Fund Taxation

Mutual funds are a popular investment tool for investors seeking to earn steady returns over the long run. Arbitrage mutual funds, in particular, are a viable solution such risk-averse investors who are seeking stable returns without exposure to market risks. These funds simultaneously buy and sell the same security in different market segments, capitalising on price differences to generate low-risk profits. 

Arbitrage fund taxation is a key consideration for investors aiming to optimise returns through low-risk mutual fund strategies. Owing to their equity-dominant portfolio (minimum 65%), these funds are taxed like equity mutual funds, offering distinct advantages over traditional debt funds. 

This article explores how arbitrage funds operate, highlights their benefits and limitations, and provides a detailed overview of arbitrage fund taxation. 

How do arbitrage funds work?

Below are the key elements of an arbitrage fund:

Step 1. Cash-and-carry method: Major arbitrage funds use this method to book profits. They buy shares in the cash (spot) market and simultaneously sell them in the futures market or vice versa. This helps them maintain a profitable position, irrespective of price movement.

Step 2. Capitalising on price differences: Say, you buy company shares at Rs. 2000 at the beginning of the month with expectation of a price increase. Then, to book your profit, you make a futures contract for Rs. 2040 with a maturity date of a month later. On that date, the arbitrage profit equals to the difference between the stock prices in the cash and future markets.

Step 3. Other arbitrage opportunities: Arbitrage funds also exploit price differences of the same stock listed on multiple stock exchanges or indexes, generating additional profits through cross-market trades.

Step 4. High trade volume: Due to marginal profits in every sale, arbitrage schemes must execute multiple trades yearly for substantial gains. Investors are encouraged to stay invested for at least 3 months. This helps reduce the impact of short-term market volatility and allows the fund to generate more stable and consistent returns over time.

Benefits and Drawbacks of Investing in Arbitrage Funds

Arbitrage funds offer several benefits as well as downsides to investors. 

Here is a table highlighting the benefits and drawbacks of investing in arbitrage funds:

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 is not more than 10% of the corpus and 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 20% 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 offer a unique blend of low risk, market-driven gains, and tax efficiency. They’re ideal for short-term investors seeking stability with returns. Start exploring arbitrage funds today through a reliable mutual fund app to make smart, informed investments with ease and convenience at your fingertips.