Make your investments more tax-efficient with these debt-oriented funds

Then there was a twist in the tale. The union budget presented on 23 July 2024 removed the indexation benefit. Now, you have to hold these investments for two years to qualify for LTCG tax of 12.5% plus surcharge and cess.

The good thing here is that the union budget presented opened up two ways to improve tax efficiency. We are talking about funds that are fixed-income-oriented and can be part of your debt allocation, but are not pure debt funds.

Fund of funds (FoFs)

You can hold these funds for two years to qualify for LTCG tax at 12.5% plus surcharge and cess. FoFs typically allocate less than 65% to debt – say 60% for the sake of discussion. The remaining 40% in this case goes to arbitrage funds. These are classified as equity funds but make no directional calls on equities, meaning returns are not dependent on equity prices moving up. They earn returns from the differential, called the spread, between the price of a stock in the cash/spot segment and the futures segment. In essence, this can be part of fixed income allocation. In arbitrage funds, the allocation to cash-futures arbitrage is usually 65-75% percent. The balance is in money-market instruments.

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For a fund to meet a certain description, such as equity or debt, 65% or more of the portfolio has to be invested in that asset. The allocation has to be 65% or more on average over the past 12 months on a rolling basis, and on the first and last working day of the month. 

For example, for a fund to be classified as an equity fund, the allocation to equity has to be 65% on this basis. For a FoF positioned for 12.5% LTCG tax over two years, you have to check the effective date. If the FoF has been restructured from another type, it will be eligible for this taxation after a year. If it has been running on this structure for more than one year, it is already eligible.

Multi-asset funds (MAFs)

Another category of mutual funds opened up for taxation purposes in April 2023. Funds with 35-65% equity allocation were eligible for LTCG tax and indexation after a holding period of three years or more. Now that the indexation benefit is gone, these funds attract 12.5% LTCG tax for a holding period of two years or more.

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The typical structure of these MAFs is less than 65% in equity, 10-15% in commodities, and the balance in debt. There is an equity component of, say 50% or 60% percent and it is not a pure debt fund. There are two ways of looking at this. One, if the asset management company does arbitrage in the equity component, it becomes a quasi-debt fund. Two, this is a hybrid fund and you may have allocation to equity in your overall portfolio. This 50-60% equity allocation in a fund should fit into your overall portfolio allocation.

Arbitrage funds

As mentioned earlier, these funds earn returns from the spread in stock prices. The price in the futures segment is usually higher than in the cash/spot segment, which is captured, even if equity prices fall. These funds are thus quasi-debt in a sense. Technically, these are equity funds, with 12.5% LTCG tax for a holding period of one year or more.

Joydeep Sen is a corporate trainer (financial markets) and author.

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