Equity fund of fund taxation rule changed: Can we invest in them now?

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Budget 2019-20 has proposed a change in short-term capital gains tax of equity-oriented fund of funds and this has resulted in some unnecessary confusion. I was asked this question twice in the last two days and I thought it best to clarify.

A fund of fund (FoF) is a mutual fund that invests in other mutual funds (do not ask why!!). As far taxation is concerned, an equity fund is one that directly invests in 65% of Indian stocks on average. Read this for exact wordings: Should I pay tax if my “equity” mutual fund holds less than 65% of equity?

Such an equity fund has short term capital gain (STCG) tax rate of 15% (+cess) if sold on or before 365 days of purchase. It also has a long term capital gains (LCTG) tax of  10%(+ cess) on gains above one lakh if sold after 365 days.

All other types of funds (other than Fofs) are classified as non-equity funds. The STCG is as per slab for gains made or before 1095 days (three years) and LTCG is 20% (+cess) for older purchases.

Does the change in equity fund of fund taxation rule make them attractive

What is an equity-oriented fund of fund?

A fund of fund that invests only in Indian equity ETFs is defined by the Taxman as an equity oriented fund of fund. All other FOFs are non-equity FOFs. For example, Quantum Fund of Fund invests in active equity mutual funds but is a non-equity FoF.

This classification was made in the 2018 budget to promote the creation of FOFs that invest CPSE ETFs (although none exist as on date). The Finance minister in his 2018 speech made it clear that:

It is proposed to provide similar tax regime as available to equity-oriented funds to Fund of Funds investing only in exchange-traded funds which only invest in listed equity shares of domestic companies

This automatically implies that STCG and LTCG from FOFs that invests in Indian ETFs will be taxed like an equity-oriented fund.

However, for some strange reason, the 2018 Finance Bill only amended the LTCG rule (section 112A) to include equity-oriented FoFs. Therefore the ministry amended the Finance Bill 2019 to allow equity-fund like STCG taxation for equity-FOFs (section 111A).

Equity-FOFs have 10% LTCG tax (above 1 Lakh) from 1st April 2019 with as-per-slab STCG tax. From 1st April 2020, they will have 10% LTCG tax (above 1 lakh) and 15%

Can we invest in Equity fund of funds now?

In a sense, not much has changed for investors. The change proposed in budget 2019 is more of a correction to the budget 2018 oversight. Equity FOFs that invest in Indian ETFs are now attractive from a tax point of view.

However, those ETFs must be worthy. For example, (1) say a mix of low volatility and quality ETFs or some such cocktail or (1) a mix of Nifty and Nifty Next 50 ETF where the weights are managed tactically. Such products will find favour among investors if introduced. Are you listening, not-so-dear AMCs?

As of now, I think there is no equity oriented fund of fund worth investing in

Update: Ram Ranganathan points out (see comments) that ICICI Prudential Passive Strategy Fund is now an equity fund. It currently invests in ICICI Pru Nifty ETF (47.14%), ICICI Pru Nifty Low Vol 30 ETF (35.41%), ICICI Pru Midcap Select ETF (16.25%)

 

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4 Comments

  1. Isn’t there an overlap between Nifty 50 and Nifty 100 Low volatility 30. Wonder what’s the point of having two etfs with an overlap even if it marginal.

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