Asset Management

Will Arbitrage funds continue to enjoy tax arbitrage going forward?

June 2024

Read Time: 3 minutes

Debt investments get taxed at a higher rate when compared to equities. The rationale being equity investments carry much higher risk and hence such investors need to be appropriately compensated by way of lower taxation.

In the mutual fund space, funds or schemes that hold 65 percent or more of assets under management (AUM) in stocks have been classified as equity funds and carry lower tax liabilities - 10 percent if held for long term and 15 percent short term.

Arbitrage funds, however, are taxed in a different manner. These schemes are taxed like equity schemes despite having risk levels comparable to debt instruments.

Such funds have 65 percent or thereabout investments in stocks that they neutralise by selling stock futures. So for instance, a Rs 1,000-crore fund would have invested Rs 650 crore in stocks and, on the other hand, would have sold Rs 650 crore worth of stock futures so that the portfolio becomes a completely hedged one.

Technically, this would come under equity fund definition because 65 percent of the portfolio is actually in stocks. But for all practical purposes, this challenges the essence behind preferential equity taxation rates because such funds end up enjoying equity tax rates for almost zero risk in the portfolio.

The gross pre-tax returns for AAA/AAA+ Debt and Arbitrage Funds would be comparable, but given the massive tax difference between the funds, good amount of flow that otherwise would have gone to debt has now switched to Arbitrage funds.

This is also one of the key reasons why banks are finding it challenging to raise deposits – the attractive post-tax returns that the Arbitrage segment is offering.

Such hugely differential taxation for broadly similar risk-return is unsustainable, and the author feels the loophole may get plugged in the forthcoming budget. Market-linked debentures (MLD) and indexation leakage got blocked last year, and there is no reason why any government would not want the incremental revenue such tax normalization would bring in to official coffers.

The segment has grown 5x in the last five months with an AUM in excess of Rs 1.50 lakh crore and with a tax differential of around 20 percent between Short Term and Debt taxations, a potential Rs 2,000 crore of tax revenue is on offer assuming Arbitrage funds give post-fee returns in range of 7 percent.

Doing so would also relieve stress on bank deposits and can easily take corporate borrowing costs down without RBI having to go down the rate cut zone.

Not just Arbitrage Funds, lots of other segments like ELSS, BAF (balanced advantage funds) etc. enjoy equity taxation for substantial lower risk than a pure 65 percent long only portfolio, but such funds have at least some net equity exposures.

In Arbitrage the net equity exposure is zero and hence it will get very tough to play devil’s advocate advocating that these funds should continue to enjoy equity taxation. The increase in tax revenues and the release of pressure on banks and corporate rates are additional factors that would tend to make government act decisively as they did with MLDs last time around.

(This article was first published in Moneycontrol)

Author: Nandik Mallik, CIO, Avendus Capital Public Markets Alternate Strategies LLP

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