The tax-smart debt fund

Summary: A 2023 tax change made debt funds less rewarding. Fund houses responded with a new category, and for high earners, the difference is Rs 17,500 on every lakh of gains. For debt fund investors, the 2023 tax change was a setback. Earlier, long-term gains enjoyed indexation benefits that reduced the tax burden. That was scrapped, and gains are now taxed at the investor’s income slab rate. Fund houses quickly responded with a new category that attempts to offer the stability of debt funds without their tax inefficiency: income plus arbitrage funds. These funds, a mix of debt and arbitrage, prove to be most useful for high earners. They lower the tax burden as they are taxed at a long-term capital gains rate of 12.5 per cent if held for at least two years, rather than slab rates applied to traditional debt funds. So on a Rs 1 lakh gain for instance, an investor in the highest tax bracket would pay Rs 30,000 in tax in a traditional debt fund. In an income plus arbitrage fund, the tax would be Rs 12,500 after two years. The savings are compelling for high-tax-bracket investors. How they work Income plus arbitrage funds are fund-of-funds (FoFs) that invest in other mutual funds. The debt component comprises debt funds across durations and issuers. The arbitrage portion (funds) captures price differences of a stock between the cash and futures markets. By allocating 35-65 per cent to arbitrage funds and the rest to debt funds, these schemes