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Economy

Tax Arbitrage Using Arb-Funds To Be Removed?

Value research says it’s likely that in the budget, Arbitrage funds will be considered debt funds for the sake of tax.

After the last budget (July 2014) you had to hold “debt” mutual funds for three years before they were considered long term. Equity funds, however, were tax-free after a year. A special species of such funds, called “Arbitrage funds” came into demand.

India loves the concept of fixed income, but hates the concept of tax. While you could get returns of 9% in debt funds, the post tax return fell to under 7% for the richest. Arbitrage funds would provide, in all probability, about 8% – a tad lower than the short term debt fund – but the returns weren’t taxed.

Debt funds, if held for a year, were earlier held to have long term capital gains taxes. Here, you could subtract inflation and pay tax only on what was extra. In a high inflation era, this meant that 9% was nearly tax free, with inflation running at around 9% anyhow.

But the 2014 budget changed that, with debt funds needing to be held for 3 years before subtracting inflation. That means your 9% was effectively taxed as income, at your highest tax slab.

People moved to equity arbitrage funds. These funds bought stocks and simultaneously sold futures, pocketing the difference. This provided opportunities of around 8-9% per year, and arb funds came into demand. So much so that a single fund (from JM) is supposed to have received a whopping Rs. 5000 cr. as fresh investment last year after the budget.

And if what Value Research is saying is true, this thing collapses like a ton of bricks. Since investors bought after the last budget (July 2014) and the next budget is now (Feb 2015) they can’t even exit easy. If they exit after the budget but before March 31, it wouldn’t be a year after they got in, so short term capital gains taxes will apply. If they exit after April 1, the new budget will come into play and they have to wait three years.

Impact on Equities

Given that it’s arbitrage, the impact on equity markets will be strange. If you have, as Value Research shows, about 10,000 cr. in such funds. If money leaves, then many such funds will have to exit their arb positions. Exiting arb positions will typically involve getting out of the cash and future position at the same time. While this should be cash neutral, the typical arb structure involves

  • Buying in the cash market once
  • Selling future this month
  • at the end of the month, “rolling over” the future position (buying back this month’s future, and selling next months)

This means the stock is only bought once and the future rolled over as long as AUM is increasing.

When AUM decreases they have to unwind the entire position. The equity position has to be sold and now.

So the impact is when they have to sell a heavy equity position, the unwinding in the cash market could cause jitters. Watch out for this unintended but interesting move if what VR says comes true: that arb funds will be treated as debt funds.

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