Jigar M. Patel
International Tax Attorney
AM Readers will recall that in this column last week, we discussed various aspects in relation to taxation of gains arising on redemption of units of debt funds. Today, we shall review the tax provisions in regard to equity oriented funds.
Taxation of Units of an Equity Oriented Fund
A fund that invests a minimum of 65% of its total proceeds in equity shares of domestic companies, listed on a recognized stock exchange, is classified as an equity oriented mutual fund (EOMF) under the Income-tax Act.
If the units of an equity fund are redeemed within 12 months of their investment, its gains are treated as short-term capital gains (STCG). Reciprocally, for units held beyond 12 months, the same are treated long-term (LTCG).
Section 111A prescribes a flat rate of 20% on STCG arising on or after 23rd July, 2024 (15% on gains prior to that date), in respect of units of EOMFs where Securities Transaction Tax (STT) has been paid at the time of their transfer.
In case of LTCG (where STT is paid), Section 112A prescribes a special rate of 12.5% (10% in respect of transfers prior to 23rd July, 2024), in respect of gains exceeding Rs. 1.25 lakhs in a financial year.
Arbitrage Funds taxed as EOMF
Arbitrage Funds are equity-oriented hybrid funds that leverage arbitrage opportunities in the market. For tax purposes, gains from units of such funds are taxed on the lines of equity funds u/s. 112A.
Hybrid Mutual Funds – the Way Forward?
Under the provisions of Section 50AA as effective until FY 2024-25, the definition of specified mutual fund covered a fund which invested not more than 35% of its total proceeds in equity shares of domestic companies. Gains arising from units of such funds are deemed as STCG and can attract tax (including surcharge and cess) of up to 39% in the case of high net-worth individuals (HNIs) in the tax bracket of income more than Rs. 2 crores.
Effective FY 2025-26, this meaning has come to be amended by providing that a fund investing more than 65% of its total proceeds in debt and money market instruments would be treated as a specified mutual fund.
Keeping in view the above, a fund that marries debt with any another asset class (not necessarily pure equity), can now avail the benefit of 12.5% tax on LTCG, to be taxed under Section 112, instead of such gains being deemed as short-term u/s. 50AA. However, in view of the definition of capital asset u/s. 2(42A), the holding period for units of such a Hybrid Mutual Fund to qualify as long-term would be two years, in comparison to an equity fund (attracting STT), where such qualifying holding period for LTCG is one year.
New category of smart tax-efficient Debt Funds
To escape the rigours of deemed STCG tax, the crucial condition is that the investment by the fund in debt must not be more than 65% of its portfolio. One of the most apt asset to pair with debt is arbitrage, so mutual funds have engineered a new product that delivers this combination.
The Mutual Fund industry has created the ‘debt advantage’ or ‘income plus arbitrage’ category. Such schemes put around 65% of the portfolio in debt and remaining 35% in arbitrage funds (reverse from what pure arbitrage funds do). From the tax perspective, LTCG of these fund units can enjoy 12.5% tax u/s. 112, with the condition of two year holding period.
