Arbitrage funds are likely to lose their tax advantage in the forthcoming budget. According to a person familiar with the development, it is almost certain that these funds would be considered as debt funds for the purpose of taxation. Arbitrage funds, which have become a favourite of conservative investors after the changes in the taxation of debt funds in the budget last year, are currently treated as equity funds. Investments in them held over a year qualifies for long term capital gains tax and investors need not pay any tax on investments in these funds held over a year.

"The issue of arbitrage funds was discussed and the finance ministry is said to have taken the decision to put them under the debt category," said the person. The ministry is said to have taken the view that these funds which look to exploit the arbitrage opportunities in different market segments (example: cash and future markets) can't be strictly termed equity mutual fund schemes.

In the last budget, the finance minister hiked long term capital gains tax on non-equity investments to 20% from 10%, and also increased the lock-in period to qualify for long-term capital gains to three years from one year. This has resulted in many debt mutual fund investors shifting their investments to arbitrage funds for better tax-adjusted returns. In fact, arbitrage funds have attracted inflows worth ₹81,796 crore between July, when the budget was presented, and December 2014. The category has given around 8.59% in the last year.

If the proposal is included in the final budget, it would be another jolt to investors who used to park their surplus cash in liquid funds to earn better tax-efficient returns. After the finance minister changed the taxation on debt funds, most of these investors shifted their money to arbitrage funds. Now, they would be forced to rework their strategy.