Arbitrage Funds for NRIs: The Tax-Efficient Way to Park Money in India Now That Debt Funds Lost Their Break

You have Rs 25,00,000 sitting idle in an NRO account, the proceeds of a property sale or a maturing deposit, and you want somewhere to keep it for the next year or two while you decide what to do with it. The relationship manager offers a debt fund and calls it tax-efficient. It is not, not anymore. The tax break that made debt funds efficient was repealed on April 1, 2023, and any debt fund you buy today is taxed at your full slab rate on the way out. The instrument that quietly inherited the "park it tax-efficiently" job is the arbitrage fund, a low-risk equity fund that earns a debt-like return but is taxed as equity. For an NRI who pays Indian tax, that difference in tax treatment is worth real money.

The 30-second answer: An arbitrage fund holds more than 65% in Indian equity and equity derivatives, so it is an equity-oriented fund for tax. That means equity taxation: 12.5% long-term under Section 112A after a 12-month hold on gains above the Rs 1.25 lakh annual exemption, and 20% short-term under Section 111A (rate effective July 23, 2024) if sold within a year. A debt fund bought on or after April 1, 2023 is taxed under Section 50AA at your slab rate with no long-term benefit, which for an NRI in the 30% bracket is far worse. Returns on both sit around 6% to 7%, so the arbitrage fund usually wins on post-tax return for a taxpaying NRI. For a non-resident, an NRE FD stays tax-free under Section 10(4)(ii) and can still beat both. US and Canada holders face a PFIC or offshore-fund overlay.

This guide is for the NRI deciding where to park rupee money for a one-to-three-year horizon, now that the debt-fund tax break is gone. I will explain how an arbitrage fund actually earns its return through cash-futures arbitrage, why that hedged structure keeps the risk low, why holding more than 65% in equity gives it equity taxation, how the 12.5% and 20% rates compare against the slab-rate hit on debt funds and the tax-free NRE FD, exactly how TDS bites on an NRI's redemption, what return to expect and where the spread can disappoint, the US and UK reporting overlay that applies to any Indian fund, a worked post-tax comparison on Rs 25,00,000 across all three options, the edge cases that flip the answer, and the honest read at the end.

How an arbitrage fund actually earns its return

The name sounds exotic, but the mechanics are simple and, importantly, low-risk by design. An arbitrage fund makes money from the price gap between the same stock in two markets at the same moment: the cash market (the ordinary stock exchange, where you buy a share to hold it) and the futures market (where you buy or sell a contract to settle that share at a date in the future).

In most market conditions the futures price of a stock trades slightly above its cash price, because the futures price embeds the cost of carrying the position to expiry (broadly, the prevailing interest rate). The fund exploits this gap. It buys the stock in the cash market and simultaneously sells the futures contract on the same stock at the higher futures price. Both legs are locked in at the same instant. At futures expiry the cash and futures prices converge, the fund unwinds both positions, and it pockets the spread it locked in at the start.

The critical feature is that the fund does not care which way the market moves. If the stock falls, the loss on the share it holds in the cash market is offset almost exactly by the gain on the futures it sold short. If the stock rises, the gain on the share is offset by the loss on the short futures. The position is fully hedged, so the return comes only from the spread, not from market direction. This is why arbitrage funds are described as market-neutral and why their returns look more like a deposit than like an equity fund: low volatility, no dependence on the index going up.

What does the fund do with the rest of the money, and during quiet periods when spreads are thin? It parks the balance in short-term debt and money-market instruments, the same place a liquid fund would. So an arbitrage fund is really a hedged-equity sleeve plus a cash sleeve, engineered to behave like a low-risk parking vehicle while qualifying, for tax, as an equity fund.

Why holding more than 65% in equity gives it equity taxation

This is the whole point of the structure, and it is worth being precise. Indian tax law defines an equity-oriented fund as one that invests, on average, at least 65% of its total proceeds in equity shares of domestic companies. An arbitrage fund deliberately keeps more than 65% of its portfolio in Indian equity and equity derivatives, so it crosses that threshold and is classified as equity-oriented for tax, even though its economic behaviour (hedged, market-neutral, deposit-like) has nothing to do with taking equity risk.

That classification is the tax advantage in a single sentence: an arbitrage fund earns a debt-like return but is taxed under the equity rules. The equity rules are materially gentler than the rules that now apply to debt funds.

Here is the equity tax treatment as it stands in 2026:

• Long-term capital gain (LTCG): if you hold the units for more than 12 months, the gain is long-term under Section 112A, taxed at 12.5%. The first Rs 1.25 lakh of long-term equity gains in a financial year is exempt, and this exemption is a single shared limit across all your equity shares and equity-oriented funds combined.
• Short-term capital gain (STCG): if you sell within 12 months, the gain is short-term under Section 111A, taxed at 20%. That 20% rate took effect on July 23, 2024; before that date the short-term equity rate was 15%.

Contrast that with the debt fund. A debt fund bought on or after April 1, 2023 is governed by Section 50AA: the gain is deemed short-term regardless of how long you held it and taxed at your slab rate, with no indexation and no long-term benefit. For a non-resident in the 30% bracket, that is 30% plus surcharge and cess on the entire gain. There is no 12-month line that turns the rate friendly. The arbitrage fund, holding more than 65% in equity, sidesteps Section 50AA entirely.

So the comparison, stripped down: same kind of return, very different tax. The arbitrage fund's worst case (20% short-term) is still below the debt fund's 30%-bracket slab outcome, and its long-term case (12.5%) is less than half.

How TDS bites on an NRI's redemption

This is where the NRI experience diverges sharply from the resident's, and it is the part most "arbitrage funds are tax-efficient" articles skip because they are written for residents.

A resident who redeems an equity fund faces no TDS. They compute the gain themselves and pay it through advance tax or self-assessment. An NRI does not get that treatment. When an NRI redeems units, the AMC is required to deduct TDS at source on the capital gain before paying out, under the withholding provisions for payments to non-residents.

The TDS rates broadly mirror the tax rates on an equity-oriented fund:

• Short-term gain (held 12 months or less): TDS at 20% plus surcharge and applicable cess.
• Long-term gain (held more than 12 months): TDS at 12.5% plus surcharge and applicable cess.

Two practical wrinkles matter for an NRI. First, the Rs 1.25 lakh long-term exemption is part of how the final tax is computed, but AMCs do not always apply it cleanly at the withholding stage; some deduct on the full long-term gain and leave you to claim the benefit of the exemption when you file. Second, surcharge stacks on top once gains are large enough, so the headline 12.5% or 20% is the floor, not always the final figure withheld.

The mechanism to recover any over-deduction is the same one I keep coming back to across these guides: file an Indian income tax return. You report the actual gain, apply the Rs 1.25 lakh exemption and the correct rate, and claim a refund of the TDS that exceeded your real liability. The TDS is a withholding, not a final tax. If you never file, the over-deducted amount simply stays with the government. For an NRI parking a large sum, this is not a trivial difference, and it is the single most common way NRIs leave money on the table with arbitrage funds.

One more operational note: TDS on an arbitrage fund is deducted per redemption, on the gain in the units you sell. If you are running a systematic withdrawal, each withdrawal triggers its own gain calculation and its own TDS, with the fund applying first-in-first-out to your units.

What return to expect, and where the spread disappoints

Be realistic about the return, because the tax efficiency only matters relative to the yield. In normal conditions arbitrage funds deliver roughly 6% to 7% a year before tax, broadly in line with what a liquid or short-duration debt fund or a bank deposit pays. That is the honest baseline to plan around.

The return is not a fixed coupon. It is the cash-futures spread, and the spread widens and narrows with two things: market volatility (more activity widens spreads, which is why arbitrage funds quietly had a strong stretch through volatile patches in 2025) and interest rates (the futures premium tracks the cost of carry, so a higher rate environment tends to support fatter spreads). When markets are calm and rates are low, spreads compress and the fund's return can dip below a comparable deposit for a stretch. There is no scenario where an arbitrage fund loses money like a directional equity fund can, but there are quiet months where it earns very little.

Cost matters too. Arbitrage funds run higher expense ratios than plain debt or liquid funds, because the strategy requires constant trading across two markets. Always compare on the direct plan rather than the regular plan, where the absence of distributor commission can save you a meaningful slice of an already modest return. On a 6.5% gross return, an extra half a percent of expenses is a real bite.

The fair summary: treat the arbitrage fund as a low-risk parking vehicle that returns around 6% to 7% with equity taxation, not as a yield play. The case for it is almost entirely the tax treatment, not the headline return, which is why it only makes sense once you have established that you are someone who pays Indian tax on the gain.

When the arbitrage fund beats an NRE FD, and when the NRE FD still wins

This is the comparison that actually decides things for most NRIs, and the answer turns on a single question: do you pay Indian tax on this money?

For a non-resident, interest on an NRE fixed deposit is exempt from Indian income tax under Section 10(4)(ii) for as long as you hold NRI status under FEMA. There is no TDS, and both principal and interest are fully and freely repatriable with no annual cap. On an India-only view, the NRE FD's post-tax return equals its pre-tax return, because the tax in India is zero. An arbitrage fund, by contrast, pays equity tax in India even at the gentle 12.5% rate. So on a like-for-like pre-tax yield, the tax-free NRE FD keeps more of the return than the arbitrage fund for a non-resident. The arbitrage fund's equity taxation is a big improvement over a debt fund, but it cannot beat zero.

So where does the arbitrage fund actually win? In three situations:

• Against taxable rupee options. When the realistic alternative is not a tax-free NRE FD but an NRO deposit or a debt fund, both of which are taxed (NRO interest at slab with TDS, debt funds at slab under Section 50AA), the arbitrage fund's 12.5% long-term rate is the most tax-efficient of the lot. Money that is stuck in NRO (for example, rental income, a property-sale corpus, or anything non-repatriable) cannot simply be moved into an NRE FD, so the comparison is arbitrage fund versus other NRO-permissible options, and there the arbitrage fund's tax treatment shines.
• When your home country taxes the NRE interest anyway. The Section 10(4)(ii) exemption is an Indian exemption. If you are a US or UK tax resident, your home country taxes your worldwide income, so the NRE interest that India does not tax is still taxable where you live. The Indian exemption gives you nothing on a net global basis. At that point the comparison resets to which instrument is more efficient overall, and the calculus shifts.
• When you want market-linked liquidity rather than a locked deposit. An arbitrage fund offers daily liquidity (subject to a short exit load, typically on units sold within 15 to 30 days). An NRE FD locks your money for the term, with a premature-withdrawal penalty if you break it. If you genuinely need the flexibility to pull money on any business day without a penalty, the arbitrage fund buys you that.

The honest framing: for a non-resident parking repatriable money on an India-only view, the NRE FD usually wins because it is tax-free. The arbitrage fund earns its place when the money is stuck in NRO, when your home country taxes the NRE interest anyway, or when you value daily liquidity over a locked rate. It is the right tool for NRO money and for the taxpaying NRI, not a universal replacement for the NRE deposit.

The US and UK reporting overlay you cannot ignore

Everything above is the India-side analysis. If you are a US or Canada person, there is a second layer that can overwhelm the Indian tax advantage entirely, and an arbitrage fund is not exempt from it just because it is low-risk.

For a US person, an arbitrage fund is an Indian mutual fund, and an Indian mutual fund is a Passive Foreign Investment Company (PFIC) under US tax law. The PFIC regime is punitive. Under the default Section 1291 rules, gains are taxed at the highest marginal rate with a compounded interest charge running back to the date you bought the units, which can swallow a large slice of the gain. The two ways out are both awkward: the QEF election requires a PFIC Annual Information Statement that Indian AMCs do not produce, so it is effectively unavailable, and the mark-to-market election taxes you each year on the unrealised increase in NAV as ordinary income, regardless of whether you sold. Either way you must file Form 8621 for each fund you hold. The low-risk, deposit-like nature of the arbitrage fund does nothing to soften the PFIC treatment; the US looks at the wrapper, not the strategy.

For a UK resident, an Indian arbitrage fund will almost certainly be a non-reporting offshore fund, which means gains are taxed as offshore income gains (OIG) at your income tax rates rather than the lower capital gains rates. The favourable Indian 12.5% equity rate has no bearing on how HMRC taxes the gain.

The practical conclusion for US and UK persons is the same one that applies to every Indian fund: the home-country overlay can erase the Indian tax advantage, and an arbitrage fund offers no special protection. If you are a US or UK person, the arbitrage fund's India-side efficiency is largely theoretical, and the NRE FD (interest, taxed simply in your home country as interest, with no PFIC machinery) is usually the cleaner choice. UAE and Singapore residents, who face no personal tax on this income at home, keep the full benefit of the Indian equity rate and are the natural audience for the arbitrage fund.

Worked example: Rs 25,00,000 across three options

Take an NRI in the 30% Indian tax bracket with Rs 25,00,000 to park for two years (so any mutual fund gain is long-term). Assume a 6.5% pre-tax return on each option for a clean comparison, ignore surcharge for simplicity, and apply a 4% cess where Indian tax is due. Over two years, 6.5% compounded gives a gross gain of about Rs 3,35,562 (Rs 25,00,000 grows to roughly Rs 28,35,562).

Option 1: Debt fund (bought after April 1, 2023, Section 50AA).

• Gross gain over two years: Rs 3,35,562.
• The gain is deemed short-term and taxed at the 30% slab rate plus 4% cess, an effective 31.2%.
• Tax: Rs 3,35,562 x 31.2% = Rs 1,04,695.
• TDS is withheld on the gain at source; the figure above is the final tax.
• Post-tax gain: Rs 3,35,562 minus Rs 1,04,695 = Rs 2,30,867.

Option 2: Arbitrage fund (equity-oriented, Section 112A long-term).

• Gross gain over two years: Rs 3,35,562.
• It is long-term equity gain at 12.5%, after the Rs 1.25 lakh annual exemption. Apply the exemption once to keep it simple: taxable gain = Rs 3,35,562 minus Rs 1,25,000 = Rs 2,10,562.
• Tax at 12.5% plus 4% cess (effective 13%): Rs 2,10,562 x 13% = Rs 27,373.
• TDS is deducted on redemption; file a return to reconcile to this figure and reclaim any excess.
• Post-tax gain: Rs 3,35,562 minus Rs 27,373 = Rs 3,08,189.

Option 3: NRE fixed deposit (Section 10(4)(ii), tax-free in India).

• Assume the same 6.5% pre-tax, so the same gross interest of about Rs 3,35,562 over two years.
• Indian tax: zero, no TDS.
• Post-tax gain in India: Rs 3,35,562.

Line them up:

Option	Pre-tax gain	Indian tax	Post-tax gain (India view)
Debt fund (Section 50AA)	Rs 3,35,562	Rs 1,04,695	Rs 2,30,867
Arbitrage fund (equity)	Rs 3,35,562	Rs 27,373	Rs 3,08,189
NRE FD (tax-free)	Rs 3,35,562	Rs 0	Rs 3,35,562

The ranking is clear and it holds at any reasonable yield. The NRE FD wins on an India-only view because it is tax-free. The arbitrage fund comes a close second and beats the debt fund by Rs 77,322 over two years on this corpus, purely because equity taxation at 12.5% is so much lighter than the 30% slab hit under Section 50AA. The debt fund is the worst of the three on tax.

Two adjustments change the picture. First, if this is NRO money that cannot go into an NRE FD, drop Option 3 and the arbitrage fund is the clear winner. Second, if you are a US person, the arbitrage fund's Rs 3,08,189 is before the PFIC machinery in the US, which can claw back a large share and drop it below the NRE FD on a net global basis. Run your own numbers with your actual yield, bracket, surcharge, and home-country tax, but the structure of the answer rarely changes: arbitrage beats debt on tax, and tax-free NRE beats both where it is available.

Edge cases

A few situations sit outside the clean rule above and deserve their own treatment.

The Rs 1.25 lakh exemption is shared, not per-fund. The annual long-term equity exemption is a single limit across all your equity shares and equity-oriented funds combined. If you have already used it on a stock sale or another equity fund in the same financial year, your arbitrage-fund long-term gain gets none of it, and the full gain is taxed at 12.5%. Plan redemptions across the financial year so you are not wasting or double-counting the exemption.

Selling within 12 months is taxed at 20%, not 12.5%. The tax advantage assumes you hold past the 12-month line. If you park money in an arbitrage fund and pull it out after eight months, the gain is short-term at 20%. That is still better than a debt fund's slab rate for a 30%-bracket NRI, but it is a worse outcome than the long-term rate you were aiming for. If your horizon is genuinely under a year, the arbitrage-fund tax edge shrinks, and a liquid debt fund's daily access may matter more than the tax line.

Exit load on early redemption. Most arbitrage funds charge a small exit load on units sold within roughly 15 to 30 days of purchase. For true short-term parking of a few weeks, that load can outweigh the modest spread you earn. The instrument is built for a hold measured in months and years, not days.

The IDCW (dividend) option is taxed differently and worse. If you hold the IDCW (income distribution cum capital withdrawal) variant rather than the growth option, distributions are taxed as income, and for an NRI the AMC deducts TDS at 20% on the distribution. For tax efficiency, hold the growth option, where the return compounds inside the fund and is realised as capital gain only when you redeem.

Spread compression in calm markets. In a low-volatility, low-rate stretch, the cash-futures spread can compress to the point where the fund's pre-tax return slips below a comparable deposit for several months. The tax advantage does not rescue a return that is not there. This is a return risk, not a capital risk, but it is the main reason an arbitrage fund can disappoint over a short window.

Returning NRIs and the status change. The equity tax rates do not change when you return to India, but your TDS position and your account designations do. Once you become a resident, you are no longer subject to NRI withholding, and the NRE FD comparison collapses because NRE interest stops being tax-free the day you redesignate the account. If a return to India is on the horizon, factor the status change into where you park money now.

The closing read

The debt fund stopped being the tax-efficient parking vehicle on April 1, 2023, the day Section 50AA forced its gains to your slab rate. The arbitrage fund inherited the role almost by accident: by holding more than 65% in Indian equity and derivatives while hedging away the market risk, it earns a debt-like 6% to 7% but is taxed under the equity rules, at 12.5% long-term or 20% short-term. For an NRI who pays Indian tax on the gain, that is a large and durable advantage over any debt fund, and the worked example puts the difference at over Rs 77,000 on Rs 25,00,000 across two years.

But tax efficiency is not the same as the best outcome. For a non-resident with repatriable money and an India-only view, the NRE FD is still hard to beat, because tax-free at the same yield beats 12.5% every time. The arbitrage fund earns its place precisely where the NRE FD cannot reach: NRO money that is stuck in the taxable rupee world, money belonging to NRIs whose home country taxes the NRE interest anyway, and investors who value daily liquidity over a locked deposit. And if you are a US or UK person, weigh the PFIC or offshore-income-gains overlay before you treat the Indian tax saving as real, because the home-country rules can erase it entirely.

The honest answer at the end: use the arbitrage fund as the tax-efficient home for NRO and taxable rupee money you want to park for more than a year, hold the growth option in a direct plan, and file your Indian return to reclaim over-deducted TDS. Keep the NRE FD for repatriable money where its tax-free status is the cleanest win available. And if you are a US or Canada resident, get your home-country adviser to confirm the fund does not turn into a reporting headache that swallows the saving.

Related guides

• Debt Funds vs Bank FDs for NRIs After the 2023 Tax Change
• Tax-Efficient Investing for NRIs
• NRE FD vs FCNR FD: Which Deposit Wins
• TDS on NRI Mutual Fund Redemptions
• NRI Mutual Fund Eligibility
• Indian Mutual Funds and the US PFIC Trap
• UK NRIs: Indian Funds and Offshore Income Gains
• PFIC-Safe Investing in India for US NRIs
• Capital Gains Tax on NRI Shares and Mutual Funds
• NRI Savings vs Fixed Deposit: Where to Park
• Reducing NRO TDS Using the DTAA
• TDS for NRIs and How to Claim Refunds
• Bharat Bond ETF and Target-Maturity Funds for NRIs
• NRI Systematic Withdrawal Plan (SWP)

Disclaimer

This guide is general information, not personal tax or investment advice. Capital gains rates, TDS provisions, the definition of an equity-oriented fund, and the Section 10(4)(ii) exemption are governed by the Income Tax Act and can change with each Budget. Arbitrage-fund returns are market-linked and not guaranteed, and past performance is not a guide to future spreads. The US PFIC and UK offshore-fund treatments are complex and fact-specific. Confirm your position with a qualified chartered accountant in India and a tax adviser in your country of residence before you act, especially if you are a US, UK, or Canada taxpayer.