In our earlier post here we had discussed the various factors which impact the returns of an arbitrage fund. Today, let us explore the taxation advantage of an arbitrage fund over debt fund.
Taxation for Arbitrage funds vs Debt Funds
Arbitrage funds are classified as equity funds and hence the returns do not get taxed after 1 year
The major taxation differential between arbitrage fund and a debt fund primarily kicks in for a 1 to 3 year investment horizon
Arbitrage funds enjoy taxation advantage over Ultra Short Term Debt Funds..
But Ultra Short Term funds generally have slightly better returns over arbitrage funds on a pre tax basis
Historically, on a 1 year basis, Ultra short term fund returns have been higher by around 0.5% to 1% over arbitrage funds on a pre tax basis
Note: Kotak Equity Arbitrage and Kotak Treasury Advantage have been used as a proxy for Arbitrage fund and Ultra Short Term Debt fund category. I have only used the data from Jan 2013 as the arbitrage fund category had undergone some changes in the way they are managed (which is beyond the scope of this article) and hence earlier data comparisons wouldn’t be too relevant.
So, putting all this together, for investment periods between 1 to 3 years
- Investors @10% taxation bracket
The taxation advantage of around 0.5 to 1% for arbitrage funds over Ultra Short Term fund gets compensated by the o.5 to 1% pre tax return disadvantage of arbitrage funds over Ultra Short Term funds.Hence investors in the 10% tax bracket can continue with Ultra Short Term funds for 1-3 year investments given their relatively lower volatility
- Investors @20% taxation bracket
The taxation advantage of around 1.5 to 2% for arbitrage funds is higher than the 0.5% to 1% pre tax return advantage of Ultra Short Term funds.So typically there is still a 0.5% to 1.5% post tax return advantage in arbitrage funds over Ultra Short Term funds for investors in the 20% tax bracket.
- Investors @30% taxation bracket
The taxation advantage of around 2% to 2.5% for arbitrage funds is higher than the 0.5% to 1% pre tax return advantage of Ultra Short Term funds.So typically there is still a 1% to 2% post tax return advantage in arbitrage funds over Ultra Short Term funds for investors in the 20% tax bracket.
This being said, please note that arbitrage fund returns may go down below our expectations, in case of a 1) bear market 2)reduced borrowing and hedging cost for FII or 3)significant size increase for the category.
- Investors in the 20% and 30% taxation bracket who also understand the risk and volatility in the arbitrage fund category may choose an arbitrage fund over an Ultra Short Term fund from a 1-3 year investment perspective
- Investors in the 10% tax bracket can continue with Ultra Short Term funds for 1-3 year investments given their relatively lower volatility
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