You redeem two funds in the same week. Both were bought on the same day thirty months ago, both took ₹4,00,000, both are worth ₹4,90,000. One is a Nifty 50 index fund. The other is an international equity fund that tracks a global index, and it is the one whose factsheet talks most about equity. The capital gains statement puts them in two different sections. On the first, the ₹90,000 gain attracts no tax at all. On the second, the identical ₹90,000 attracts ₹11,250 — and not because the rate is higher, because it is not. A definition in the income-tax law has sorted the two funds into different buckets, and the sorting has almost nothing to do with what you thought you were buying.
Two neighbours buy the same model of car in the same week. One registers it as a private vehicle and the other, because it will occasionally be hired out, registers it as a commercial one. Same engine, same road, same driver on most days — and different road tax, different insurance, different rules on where it may be parked. Nothing about how the car drives explains the difference. A test was applied at the registration counter, once, and the answer it produced is written on the RC and follows the vehicle around.
A fund is classified the same way. The income-tax law has its own test, applied to what the scheme actually holds, and the answer decides how long you must hold for a gain to be long-term, at what rate it is taxed, and whether an annual exemption is available. What the test does not look at is the name of the fund, the category SEBI has put it in, or the exposure it gives you. Two products that behave identically in your portfolio can carry different classes on the RC.
The test, and the three words that do the work
The income-tax law defines an equity oriented fund for itself, and the definition is not the same thing as SEBI's scheme categories. Broadly, in the ordinary case, at least sixty-five per cent of the fund's proceeds must be invested in equity shares of domestic companies listed on a recognised stock exchange. There is a second route for a fund that invests through another fund, and it is stricter: at least ninety per cent into units of another scheme that is itself traded on a recognised stock exchange, where that other scheme in turn puts at least ninety per cent into the same kind of shares.
| What you hold | What it actually owns | Does it clear the test? | The part that surprises people |
|---|---|---|---|
| A Nifty 50 [[index fund]] | Equity shares of domestic listed companies, at essentially the whole of the portfolio | Yes, comfortably | Nothing surprising here, and it is the reference case for every row below it |
| A Nifty 50 ETF | The same shares | Yes | The same bucket as the index fund. What differs is the plumbing: you buy it on the exchange at a price rather than at NAV, and you pay brokerage and a bid-offer spread that the index fund route does not have |
| A [[fund of funds]] that feeds an ordinary index fund | Units of another mutual fund scheme | No | It holds units rather than shares, so the sixty-five per cent limb cannot be satisfied; and the ninety per cent limb needs the underlying scheme to be exchange-traded, which an ordinary index fund is not. Identical exposure to row one, different bucket |
| An international equity fund | Shares of companies listed abroad, or units of an overseas scheme | No | It fails on domestic, however much equity it holds and however well diversified it is. This is the clearest case of the economics and the classification pointing in opposite directions |
| A gold ETF, or a gold fund of funds | Gold, or units of a scheme that holds gold | No | Gold is not an equity share, so neither wrapper qualifies. A sovereign gold bond is a third thing again, taxed under rules of its own, which is why the same metal reaches you under three different tax treatments |
| An [[arbitrage fund]] | Domestic listed equity above the threshold, with an offsetting short position in futures | Yes | The economics are close to a money-market fund and the classification is equity. The test asks what the scheme holds, not what the holding has been hedged with |
- Holds the shares themselves, so the sixty-five per cent test is met directly
- Long-term after twelve months, at the concessional equity rate, with the annual exemption available
- Brokerage and a bid-offer spread on the ETF route, neither of which the index fund route has — and a small STT on redeeming equity-oriented units, which applies either way
- One layer of expense ratio
- Holds units, so it cannot satisfy the sixty-five per cent limb at all
- Falls in the residual bucket: a longer qualifying period, and no annual exemption on the gain
- No STT at all, because the levy on redeeming units reaches only equity-oriented ones — which is the bucket answering back in your favour, for once, and for a rounding error
- Two layers of cost, the feeder's and the underlying scheme's — which is a separate reason to look, and a smaller one than the tax
Which bucket, and why
Answer with the reason, not just the bucket. Five wrappers.
You want Nifty 50 exposure and are choosing between a Nifty 50 index fund and a fund of funds that invests in that same index fund. Assume identical returns before costs. What is the position on tax?
Do fund, ek hi din ₹4,00,000 dono mein, 30 mahine baad dono ₹4,90,000 — gain ₹90,000 dono pe. Ek Nifty 50 index fund, doosra international equity fund of fund. Pehle pe tax zero, doosre pe ₹11,250 — aur rate dono pe wahi 12.5%. Farak rate ka nahi, class ka hai. Income-tax ka apna test hai: "equity oriented" banne ke liye kam se kam 65% paisa domestic, listed companies ke equity shares mein (saal bhar ka average, ek din ka photo nahi). Teen shabd, teen chhalni: equity shares — sona aur units bahar; domestic — America ke share kitne bhi ho, fail; listed — unlisted ginte nahi. Fund of fund ka apna raasta hai aur woh aur sakht hai: 90% kisi exchange-traded scheme mein, aur woh scheme khud 90% aise hi shares mein. Isliye jo FoF ek saadhe index fund ko feed karta hai, woh kisi bhi limb se pass nahi hota — exposure Nifty ka hi hai, bucket doosra. Do ulti misaal yaad rakho: arbitrage fund kaam FD jaisa karta hai par tax mein equity hai (test poochta hai kya rakha hai, hedge kya kiya — nahi); aur international equity fund kaam equity ka karta hai par tax mein equity nahi. Aur zero vs ₹11,250 ka poora farak? Woh annual exemption hai, jo bucket ke saath chipki hai, aapke saath nahi. Isliye naam aur exposure se nahi — kya rakha hai, aur kis wrapper mein, yahi poochho. (Rate misaal ke liye. 2018, 2023 aur 2024 — teen baar rate badle, test ek baar bhi nahi.)
- The income-tax definition of an equity-oriented fund is its own test and is not SEBI's scheme category.
- Three qualifiers do the work — equity shares, of domestic companies, listed on a recognised stock exchange — and failing any one is enough.
- A fund of funds needs ninety per cent into an exchange-traded scheme that itself holds ninety per cent in such shares, so a feeder into an ordinary index fund fails.
- An arbitrage fund is equity for tax while behaving like a money-market fund; an international equity fund is the reverse.
- The bucket decides the qualifying period, the rate and the annual exemption — and the rates have changed repeatedly while the test has not.
Mark it done to track your progress through the curriculum.