You can reduce tax liability under new regime with an Income Plus Arbitrage FoF. Is it worth it?

Income Plus Arbitrage Fund of Funds (FoF) is a recent innovation of mutual fund asset management companies (AMCs) in response to tax changes announced in the Union Budget presented in July 2024. It promises to offer returns like debt funds and tax benefits like an equity mutual fund.

Income Plus Arbitrage FoF invests in a mix of arbitrage and debt funds in a way that its exposure to debt is not more than 65% and exposure to arbitrage is not more than 35%.

The main objective of these FoFs is to deliver lower taxation with debt-like stability in terms of returns. You can pay just 12.5% tax by holding your investment in these FoFs for more than two years. If units are held for less than two years, then the gains will be taxed as per the applicable slab rate of the individual.

For example, suppose your gain from investment is ₹5 lakh, then

• In a traditional debt fund, you will have to pay 30% tax (if you are in the highest tax slab), which is ₹1,50,000.

• In income plus arbitrage FoF, you would need to pay just 12.5% tax on ₹5,00,000, which is approx. ₹62,500, which is a tax saving of around 60%.

How has it evolved?

Union Budget 2023 made gains from all debt funds taxable at investors' slab rates. As a result, investors in the highest tax slab have to pay 30% tax on gains from their debt fund investments. However, the Union Budget presented in July 2024 sweetened the FoF category. The Finance Minister then announced just a 12.5% tax on long-term capital gains (LTCG) from FoF, but with two conditions:

• First, it should be held for over two years to be eligible for a 12.5% tax on LTCG.

• Second, it should not hold more than 65% in debt instruments.

AMCs took advantage of the tax rule change in 2024 by launching new FoFs or restructuring existing schemes and ensuring they do not breach the 65% debt instrument cap by adding exposure to arbitrage funds.

Are Income Plus Arbitrage FoF worth it?

To decide whether this new FoF category is worth investing or not, you may consider the following points:

First, investing in a fancy new instrument just for tax-saving may not be a good move. If you are not familiar with debt funds, you may be better off staying away from the new scheme on offer.

Second, the debt portion of your portfolio can be filled with various government-backed schemes that offer guaranteed returns.

Third, in case you want to invest exclusively in debt instruments through mutual funds, then you should first familiarise yourself with debt funds as well as the Income Plus Arbitrage FoFs. This is because the risks are higher. You should also seek help from a financial advisor if planning to invest a large amount in this category.

Fifth, the tax advantage of the Income Plus Arbitrage FoF provides a compelling reason to invest for those in the highest tax bracket. However, this is a new category, and there isn't enough track record to say how they may perform in different market cycles.

Lastly, FoFs are not easy to comprehend. They track other funds, which may keep changing. Moreover, the underlying funds may also change their strategies from time to time. Therefore, keeping track of so many underlying funds will not be an easy task.