Taxation of arbitrage funds (equity-oriented)
Taxation of arbitrage funds in India mirrors the taxation of equity-oriented mutual funds because SEBI mandates that arbitrage funds maintain at least 65% of their assets in equity (through simultaneous long cash and short futures positions), placing them within the equity-oriented classification for income-tax purposes. Capital gains on arbitrage fund units are taxed under Section 111A (STCG at 20%, effective 23 July 2024) if held for 12 months or less, or under Section 112A (LTCG at 12.5% above Rs 1,25,000) if held for more than 12 months. This tax treatment makes arbitrage funds materially more efficient than liquid funds or ultra-short-duration debt funds for investors in higher income-tax brackets, especially for parking short-term surpluses for periods of three months or more.
Tax advice disclaimer. This article is for educational reference only and does not constitute professional tax or financial advice. Tax law changes frequently and individual circumstances vary widely. Readers should consult a qualified Chartered Accountant or tax adviser before making any investment or tax-filing decision.
What is an arbitrage fund
An arbitrage fund is a SEBI-defined open-ended scheme that exploits price differentials between the cash (spot) market and the futures market for the same underlying equity security. The fund simultaneously:
- Buys shares in the cash segment (long position); and
- Sells equivalent futures contracts (short position).
The gross exposure to equity (both long cash and short futures) must be maintained at or above 65% of net assets under SEBI’s categorisation circular. The net unhedged equity exposure is minimal; the fund’s return is derived from the roll spread (the premium of near-month futures over spot prices) rather than directional equity movement.
Because the fund holds at least 65% of assets in equity shares (the cash-leg positions), it qualifies as an equity-oriented fund under Section 112A(10). The futures leg is not equity for this test; only the cash equity holding counts.
Tax classification
Arbitrage funds are equity-oriented. The taxation rules are identical to those for actively managed equity mutual funds:
| Holding period | Applicable section | Tax rate (post-23 July 2024) |
|---|---|---|
| Up to 12 months | Section 111A | 20% STCG |
| More than 12 months | Section 112A | 12.5% LTCG (above Rs 1,25,000) |
STT is paid on the equity cash-leg transactions as well as on the futures transactions, satisfying the STT condition for Section 111A and Section 112A.
Comparison with liquid and overnight funds
For an investor in the 30% income-tax bracket:
| Fund type | Tax on gain (3-6 months holding) |
|---|---|
| Liquid fund / overnight fund (post-April 2023) | 30% slab rate (short-term, specified MF) |
| Arbitrage fund (up to 12 months) | 20% (Section 111A STCG) |
The tax saving for the high-bracket investor is 10 percentage points of the gain. Even after accounting for the 20% STCG rate that applies post-Finance Act 2024 (previously 15%), arbitrage funds remain more tax-efficient than debt MFs for short-term parking. Prior to 23 July 2024, the STCG rate on arbitrage funds was 15%, making the advantage even larger.
For investments held beyond 12 months, the LTCG rate of 12.5% (above Rs 1,25,000) applies, retaining the advantage over debt funds.
Pre- and post-Finance Act 2024 rate comparison
The Finance Act 2024 raised the Section 111A rate from 15% to 20% effective 23 July 2024. For arbitrage funds specifically, this reduced but did not eliminate the tax advantage over debt funds. Most arbitrage fund investors use the product for sub-12-month periods, where:
- Before 23 July 2024: 15% vs 30% = 15pp advantage.
- From 23 July 2024: 20% vs 30% = 10pp advantage.
Grandfathering
Section 55(2)(ac) grandfathering applies to arbitrage fund units acquired before 1 February 2018 that are redeemed as LTCG. In practice, most arbitrage fund investments are shorter-term and are unlikely to involve pre-2018 units; however, the provision applies in principle. Details are in equity MF grandfathering (31 January 2018).
IDCW income
IDCW from arbitrage funds is taxed at slab rates and subject to TDS at 10% under Section 194K if aggregate IDCW exceeds Rs 5,000.
Dividend stripping risk
Section 94(7) dividend stripping is particularly relevant for arbitrage funds because the funds often distribute IDCW to attract investors. A loss arising on units purchased within three months before the record date and sold within nine months thereafter is disallowed to the extent of the IDCW received.
Reporting
STCG from arbitrage funds is reported in Schedule CG of ITR-2 or ITR-3 under the Section 111A head. LTCG is reported under the Section 112A head. Reconciliation with Annual Information Statement (AIS) data is recommended.
See also
- Equity mutual fund taxation in India
- STCG on equity MFs (Section 111A)
- LTCG on equity MFs (Section 112A)
- Hybrid mutual fund taxation
- Debt mutual fund taxation (post-April 2023)
- Securities Transaction Tax
- Dividend stripping disallowance (Section 94(7))
- Capital gains tax in India
- MF IDCW TDS for residents
References
- Income Tax Act 1961, Section 111A (as amended by Finance Act 2024).
- Income Tax Act 1961, Section 112A(10) – equity-oriented fund definition.
- Finance Act 2024, revision of Section 111A rate.
- SEBI Circular on Categorisation and Rationalisation of Mutual Fund Schemes (October 2017) – arbitrage fund mandate.
- Income Tax Act 1961, Section 94(7) – dividend stripping.
- Income Tax Act 1961, Section 194K – TDS on mutual fund IDCW.