In Indian financial landscape, tax arbitrage has a tool for retail investors and multinational corporations. It is practice of exploiting differences in tax rates, regulations, or classifications between two or more systems to reduce overall tax liability.
In India, this rarely involves illegal tricks; instead, it leverages specific way Income Tax Act treats different financial instruments.
1. Popular Tax Arbitrage Strategies in India
Tax arbitrage is primarily driven by the mismatch between how different types of income (interest vs. capital gains) are taxed.
A. Arbitrage Mutual Funds (The Retail Favorite)
This is most common form of domestic tax arbitrage. Arbitrage funds profit from price difference between Cash Market and Futures Market.
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Mechanism: A fund manager buys a stock in cash market and simultaneously sells it in futures market.
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Arbitrage: Despite behaving like a low-risk debt instrument (yielding returns similar to a Liquid Fund), these are classified as Equity Funds for tax purposes.
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Benefit: Investors pay a lower tax rate (20% for Short-Term Capital Gains) compared to Debt Funds or FDs, which are taxed at individual’s income tax slab (which can be as high as 30-37%).
B. Dividend vs. Growth Arbitrage
Investors often choose between Growth and IDCW (Income Distribution cum Capital Withdrawal) options.
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Dividends: Taxed at your slab rate.
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Capital Gains: Taxed at fixed rates (12.5% for LTCG after a ₹1.25 lakh exemption).
By opting for Growth, high-net-worth individuals arbitrage higher slab rate by converting potential dividend income into lower-taxed capital gains.
C. Buyback Arbitrage (Post-2024/25 Reforms)
Historically, companies used buybacks to distribute profits because they were more tax-efficient than dividends. However, under Income Tax Act 2025 (effective April 1, 2026), buyback proceeds are now taxed as capital gains for shareholders. While gap has narrowed, strategic timing of buybacks still allows investors to use capital losses to offset gains, a move not possible with dividend income.
2. Global Tax Arbitrage (MNCs)
For corporations operating in India, arbitrage often involves Base Erosion and Profit Shifting (BEPS):
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Jurisdictional Arbitrage: Shifting profits to low-tax regions while booking expenses in high-tax regions like India.
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Entity Classification: Using hybrid entities that are treated as transparent (pass-through) in one country but as a corporation in India, allowing for double deductions.
3. 2026 Regulatory
The Indian government has significantly tightened net on aggressive arbitrage.
| Feature | Impact on Arbitrage in 2026 |
| STT Hike | Budget 2026 increased Securities Transaction Tax (STT) on futures (0.02% to 0.05%), narrowing the profit margins for arbitrage funds. |
| LTCG Rates | The uniform 12.5% rate for Long-Term Capital Gains has simplified calculations but removed some niche arbitrage playbooks. |
| GAAR | General Anti-Avoidance Rule (GAAR) allows tax authorities to deny tax benefits if sole purpose of a transaction is tax reduction without commercial substance. |
4. Risks
It is vital to distinguish between Tax Planning (legal arbitrage) and Tax Evasion (illegal).
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Legal: Investing in an Arbitrage Fund specifically because of its equity taxation status.
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Illegal: Misrepresenting the nature of a transaction or using shell companies to create artificial losses.
Summarize..
| Investment Type | Nature of Risk | Tax Treatment | Best For |
| Fixed Deposit | Zero | Income Slab (up to 30%+) | Safety, small amounts |
| Liquid Fund | Low | Income Slab (Debt taxation) | Ultra-short term (days) |
| Arbitrage Fund | Low | Equity (20% STCG 12.5% LTCG) | Tax-efficient parking (1–6 months) |