Arbitrage fund taxation

THE wave of volatility has taken the stock market in the full grip. Not that Indian 

stock markets have tumbled, the world over the wave of volatility has only been 

gaining strength ever since the US Federal Reserve decided to hike the rates, 

which were at sub-zero level for years. 

Now that the panic is palpable on the street, and the retail investors are arguably 

rushing in to liquidate their mutual fund and other equity holdings, the arbitrage 

fund is being seen as viable option to park short term funds. Incidentally, the 

arbitrage funds are popularly known as instruments of investments in the times of 

volatility. 

With interests on short term saving instruments coming down, retail investors have 

begun inquiring about the arbitrage funds, which had for long been the destination 

of institutional investors and high net-worth investors (HNIs). After the 

government in 2014 tweaked the tax rules for short term debt funds, the arbitrage 

funds were seen better option for those who have liquid money. So, number of 

arbitrage funds is on the rise, and they have given return in the range of eight to 10 

pert cent a year.

In contrast, return on savings with banks have stayed in 4-5 per cent range, with a 

few giving even six per cent but now more on the condition that relatively higher 

sum be parked in the account.

WHY is the arbitrage funds gaining attention?

The reason lies in one simple tax rule change for the short term debt fund, 

which began attracting a cumulative dividend distribution tax (DDT) of 28.33 per cent.

In contrast, arbitrage funds are treated at par with equity funds, and thus the 

investors pay zero tax on dividend. 

Additionally, if the arbitrage fund is held for more than a year, there is no long 

term capital gains tax as well. 

Incidentally, the Finance Bill introduced in the Lok Sabha in July 2014 after the 

new government under Prime Minister Narendra Modi came to power tweaked the 

tax rule to make the short term debt fund unfavourable, and thus gave more 

incentive to invest in the equity market. The arbitrage funds by nature are largely 

equity oriented. After the 2014 tax changes, the arbitrage funds are seen better 

options than the short term debt funds and short term liquid funds.

But the scenario before July 2014 was different. Liquid funds or short term funds 

till then used to give a return close to 9-9.5 per cent and even after dividend distribution 

Tax (DDT) of around 15 per cent (then), investors used to make a sweet interest of about 

eight per cent. 

And with no exit load on the fund at that time an eight per cent return was 

arguably better than most of the instruments. And, hence, institutional investors 

and high net-worth investors (HNIs) took fancy with the short term debt funds. 

But the July 2014 Finance Bill changed the rule of the game against the short term 

debt funds, as they began attracting DDT of 28.33 per cent. The Bill also 

abolished the benefit of paying tax at 10 per cent before indexation (adjusting 

value with inflation) over the long term. Adding to their woes, the emerging 

scenario of falling interest rates and excessive liquidity in the financial system 

dipped returns on them to around 8 per cent, which after DDT meant only about 

5.5 per cent for the investors. Thus, they became as good as saving account 

interests offered by a few banks.

In contrast, arbitrage funds are treated like an equity fund for taxation purposes. 

Thus, an investor gets to save 28.33 per cent of the DDT as is in the case of short 

term debt funds. With the average arbitrage funds return being about 8.5 per cent, 

an investor, if he stays for a year at least, pockets a relatively high interest, which 

is arguably not given by many of the short term saving instruments.  

Now that the retail investors are also evincing interests in the arbitrage funds, the 

natural question on their minds must be if they are safe. The fund managers are 

mostly of the opinion that such funds are safe.

HOW does an arbitrage fund function?

Simply put, the arbitrage fund manager takes the advantage of the price difference 

between the share price in cash and future market. A fund manager buys a stock in 

cash and sell in futures market. The difference is the return on the fund. 

For the sake of illustration, the fund manager may bu shares in the beginning of 

the month of, say, Reliance Industries are Rs 950 in cash market, which, say, may 

be trading at Rs 985 in the future market. By selling the share in the future market, 

he would make the profit. And, so, arbitrage funds make money by gaining from 

difference in price of a security in different markets. Towards the end of the month 

the prices in both the markets may converge. The fund manager reverses the 

position by selling in cash market and buying it back in futures.  

However, arbitrage funds have introduced exit load of 0.25 to 0.50 per cent for a 

period of 30 to 90 days to dissuade very short term investors. And, hence, it may 

not interest those who have time span less than 90 days. It may also be borne that 

the fund managers believe arbitrage funds do better mostly in volatile markets, 

because of the gains they make through wide gap in prices in cash and derivatives 

segments. But they also add that the markets should be in a bullish phase, and not 

caught in the tight grip of bears. 

Thus, the fund used to hedge against risk should be left for the experts who are 

equipped with technical software to spot opportunities.