Previously, investments in ETFs and FoFs faced distinct tax rules, but the new regulations have streamlined these, creating a more favourable environment for ETFs. This shift not only reduces the time needed to benefit from long-term capital gains (LTCG), but also enhances trading convenience, positioning ETFs as the preferred choice for savvy investors looking to optimise their portfolios.
ETFs are bought and sold via stock exchanges and held in demat accounts. In contrast, FoFs are held in statement of account form (with registrar and transfer agents, or RTAs) and are bought directly from asset management companies (AMCs) and redeemed directly with AMCs.
Old vs new regime
ETFs: Before April 1, 2023, investments in gold, silver and overseas ETFs were subject to LTCG tax if held for more than 36 months—taxed at 20% with indexation benefits. Short-term capital gains (STCG) for these ETFs were taxed at the investor’s applicable income tax rate.
FoFs: Commodity (gold and silver) and overseas funds followed similar tax rules but were classified differently.
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The 2023 Budget had redefined the tax treatment and holding periods for these investment vehicles, making them taxable at the slab rate. It had grandfathered investments made before April 2023, allowing them to enjoy the benefits of 20% with indexation.
However, the Budget for 2024-25 made another change. For redemptions made after 31 March 2025, the holding period for capital gains calculation has been standardized to 24 months. This adjustment aligns the treatment of these instruments with other assets but gives ETFs an advantage over FoFs due to the reduced holding period.
ETFs and FoFs are both taxed at the slab rate in the short term, and 12.5% in the long term. However, the holding period for ETFs to be considered long-term is 12 months because they are listed securities, while it is 24 months for FoFs.
Benefits of ETFs over FoFs
With the same tax treatment but different holding periods, ETFs now present a more attractive option for investors. The benefits of choosing ETFs over FoFs are multifaceted.
ETFs now have a reduced holding period of 12 months compared to the 24 months required for FoFs to qualify for LTCG tax. This shorter holding period makes ETFs a more flexible and appealing option for investors aiming to optimize their tax liabilities. So, if you hold a Gold ETF for just over a year, you’ll enjoy the 12.5% LTCG tax rate. With FoFs, you’d need to wait two full years for that benefit. It’s a clear win for ETFs in terms of tax efficiency.
While both ETFs and FoFs are taxed similarly under the new regime—slab rate for STCG, and 20% with indexation benefits for LTCG—the shorter holding period for ETFs means investors can benefit from the lower LTCG tax rate sooner.
Moreover, ETFs offer trading convenience as they are traded on the stock exchanges, allowing for intraday trading, liquidity, and price transparency. This flexibility is not available with FoFs, which are typically bought and sold at the end of the trading day at the fund’s net asset value (NAV). For instance, if you need to quickly liquidate an ETF, you can do it anytime during market hours. With an FoF, you’d have to wait until the end of the day to make your move.
Additionally, ETFs generally have lower expense ratios compared to FoFs, making them a more cost-effective choice for long-term investors. This is another area where ETFs shine. Generally, ETFs have lower expense ratios because they passively track an index and don’t require active management. FoFs, however, usually come with higher fees due to the extra layer of fund management
Besides, ETFs provide targeted exposure to specific sectors, commodities, or international markets, enabling you to customize your portfolio to your precise needs. If you want to invest specifically in international technology stocks, for instance, there’s an ETF for that. An FoF, however, might give you broader exposure that includes multiple sectors, which might not align with your targeted investment strategy.
However, investing in ETFs requires a demat account, which may not be necessary for FoFs. This requirement can be a barrier for some investors who are not familiar with the stock market operations or prefer the simplicity of investing through mutual funds.
Note: for equity ETFs and FoFs investing heavily in equity funds (over 65% in stocks, and over 90% in equity funds, respectively), the tax rate is 20% for short-term gains and 12.5% for long-term gains. These ETFs fall under Sections 111A or 112A, with a 12-month holding period for long-term classification.
In contrast, pure debt ETFs and FoFs, with significant investments in debt and money market instruments, are taxed at the slab rate, regardless of the holding period under Section 50AA of the Income Tax Act, 1961.
Conclusion
The new tax regime favours ETFs over FoFs for asset classes such as gold and overseas equity, primarily due to the shorter holding period required to benefit from LTCG tax rates.
This advantage, combined with the inherent benefits of ETFs such as liquidity, lower costs, and trading flexibility, makes them an increasingly attractive option for investors in gold, silver, and overseas markets.
