Arbitrage funds occupy a distinct place in the investment landscape. They follow a market neutral strategy, typically buying in the cash market and selling in the futures market, to capture price differentials, which helps keep volatility relatively low compared to traditional equity funds.
Despite this relatively stable return profile, arbitrage funds are classified as equity schemes for taxation purposes, as they maintain the required equity exposure. This means their tax treatment can be more favourable than that of other lower volatility options such as liquid or short duration debt funds.
Therefore, when comparing arbitrage funds with bank fixed deposits, liquid funds, or short duration debt funds, it may be useful to look beyond headline returns and consider applicable tax rates and post-tax outcomes.
Introduction to arbitrage fund taxation
An arbitrage fund is a mutual fund scheme that seeks to capture price differences between the cash market and the derivatives market. Although the strategy is hedged and typically less volatile than many diversified equity funds, arbitrage funds are classified as equity-oriented mutual funds for taxation purposes when they maintain the prescribed equity exposure. Such funds generally keep more than 65% exposure to equity and equity-related instruments under normal circumstances, which supports their equity-style tax treatment.
This classification is the central factor in taxation. Arbitrage funds are not taxed like most debt funds or fixed deposits. Instead, capital gains are taxed under the equity mutual fund framework. For investors, this can materially change the post-tax outcome.
A scheme delivering modest returns may still appear relatively tax-efficient if the applicable rate is lower than the investor’s income tax slab. For this reason, arbitrage funds may be considered for short-term allocation of surplus funds, treasury-style deployment, or as a temporary allocation before phased investment into equity markets.
Short-term capital gains (STCG) vs long-term capital gains (LTCG) on arbitrage funds
Understanding how short-term and long-term capital gains are taxed can help you better evaluate the post-tax returns from arbitrage funds:
| Particulars | Short-term Capital Gains (STCG) | Long-term Capital Gains (LTCG) |
| Holding Period | Up to 12 months | More than 12 months |
| Tax Section | Section 111A | Section 112A |
| Tax Rate (Post 23 July 2024) | 20% | 12.50% |
| Exemption Limit | No exemption | ₹1.25 lakh per financial year on aggregate gains |
| Applicability | When units are redeemed within 12 months | When units are held beyond 12 months |
| Tax Efficiency Consideration | May be less tax-efficient for investors in higher tax brackets | May be more tax-efficient if gains exceed the exemption threshold |
| Relevance for Investors | Suitable for very short-term allocation where liquidity is key | May be considered for slightly longer holding periods to optimise post-tax returns |
Taxation’s impact on returns
Taxation can significantly influence the effective potential returns of an arbitrage fund. For example, if an arbitrage fund and a bank fixed deposit generate similar pre-tax annualised returns over a period, the tax treatment differs. Fixed deposit interest is taxed at the investor’s slab rate, whereas gains from an arbitrage fund are taxed at 20% if redeemed within 12 months, or at 12.5% after the exemption threshold if held for more than 12 months.
For investors in higher tax brackets, this difference may make arbitrage funds appear relatively more tax-efficient on a post-tax basis even when the gross potential return is comparable.
Comparison with debt funds is also relevant. Taxation of debt funds changed in recent years, and investments made on or after 1 April 2023 are taxed at slab rates instead of benefiting from the earlier indexation-based long-term regime.
This change reduced the tax advantage debt funds previously offered to some investors. In contrast, arbitrage funds may continue to receive equity-oriented taxation when structured in accordance with regulations. As a result, they may be considered by investors seeking relatively lower-volatility deployment without automatically falling into income slab-rate taxation.
Tax filing considerations
Tax liability arises in the financial year in which units are redeemed, not during the holding period. If units are purchased in one year and redeemed in another, the capital gain is reported only in the year of redemption. In limited situations where eligibility conditions are met, certain long-term capital gains cases may be reported in ITR-1; however, investors with mutual fund capital gains commonly use ITR-2 for more detailed reporting.
For long-term capital gains under Section 112A, reporting may require scrip-wise or transaction-wise disclosure depending on the return form and reporting requirements. Investors may therefore consider avoiding delays in reconciliation until the filing deadline. Capital gains statements can be downloaded from the AMC, registrar and transfer agent (RTA), broker platform, or consolidated account statement (CAS) provider and matched with bank records and the Annual Information Statement, where available. Maintaining accurate records may reduce the likelihood of discrepancies or notices.
If investors receive IDCW (Income Distribution cum Capital Withdrawal) payouts from an arbitrage fund, the amount is taxable at the investor’s applicable slab rate. The earlier dividend distribution tax regime no longer applies. Under Section 194K, mutual funds deduct tax at source on IDCW payouts to resident investors when the prescribed threshold is crossed. From 1 April 2025, this threshold is ₹10,000. Accordingly, investors receiving IDCW payouts in 2026 may need to track both gross receipts and TDS credits while filing returns.
Conclusion
Taxation remains one of the key factors underpinning the relevance of arbitrage funds in 2026. These schemes are not designed for high return potential, but they may offer relatively low-volatility deployment while qualifying for equity-style taxation. When an investment category combines such characteristics, it may be considered for short-term portfolio planning, subject to individual risk tolerance and financial goals. Under the current regime, gains on units held up to 12 months are taxed as STCG at 20%. Gains on units held beyond 12 months are taxed as LTCG at 12.5% after the ₹1.25 lakh exemption on eligible long-term gains. IDCW payouts are taxable at slab rates, with TDS provisions under Section 194K applying above the prescribed threshold.
The tax information (if any) in this article is based on prevailing laws at the time of publishing the article and is subject to change. Please consult a tax professional or refer to the latest regulations for up-to-date information.
FAQs
What is the taxation structure for arbitrage funds in India?
Arbitrage funds are generally taxed as equity-oriented mutual funds if they maintain the prescribed equity exposure. Accordingly, capital gains are taxed under the equity capital gains framework rather than the slab-rate structure applicable to most debt funds.
How are short-term and long-term capital gains taxed in arbitrage funds?
If units are redeemed within 12 months, gains are taxed as STCG at 20% for transfers on or after 23 July 2024. If units are held for more than 12 months, gains are taxed as LTCG at 12.5% under Section 112A after the ₹1.25 lakh annual exemption on eligible long-term gains.
What is the tax advantage of holding arbitrage fund units for more than one year?
Holding units beyond one year shifts taxation from the 20% STCG regime to the 12.5% LTCG regime and also provides the benefit of the ₹1.25 lakh exemption threshold for eligible long-term gains. This may improve post-tax outcomes compared with short-term holding, depending on individual circumstances.
How does taxation of arbitrage funds compare with debt funds or fixed deposits?
Arbitrage funds typically receive equity-style taxation, whereas fixed deposit interest is taxed at the investor’s slab rate and many debt fund investments made on or after 1 April 2023 are also taxed at slab rates. For investors in higher tax brackets, arbitrage funds may therefore be relatively more tax-efficient on a post-tax basis.
Are IDCW payouts from arbitrage funds taxable and how are they treated?
Yes. IDCW (Income Distribution cum Capital Withdrawal) payouts from mutual funds are taxable in the hands of the investor at the applicable slab rate. Under Section 194K, tax is deducted at source when the payout exceeds the prescribed threshold, which is ₹10,000 from 1 April 2025.
