Tax Treatment — Equity vs Debt vs Hybrid Funds
Tax law sorts mutual fund schemes into three groups by what they hold: equity-oriented funds, specified mutual funds and all other funds. This lesson explains the tests and what each group means for tax, as of October 2026.
Why the group matters
When mutual fund units are sold for more than they cost, the profit is a capital gain. Its tax depends on how long the units were held and on the scheme's tax group, which sets both the holding period for a long-term gain and the rate.
The grouping comes from tax law, not from a scheme's name. It looks at what the scheme actually holds, so two schemes with similar names can fall in different groups.
The three tests
An equity-oriented fund holds at least 65% in listed domestic equity shares. The percentage is measured as the annual average of the monthly averages, so the scheme is not judged on one day's portfolio.
A specified mutual fund holds more than 65% in debt and money-market instruments, or is a fund-of-funds with 65% or more in such funds. This definition has been in force from 1 April 2025. Liquid, overnight and corporate bond funds belong here.
Every other scheme forms the third group: hybrids that fall between the two tests, gold and silver funds, and international equity funds.
Cases that catch people out
An arbitrage fund holds at least 65% in equity shares and hedges them with futures. It meets the equity-oriented test even though the positions are hedged, and it still carries its own risks and costs. An international equity fund holds shares, but not listed domestic equity shares, so it falls in the third group.
A fund-of-funds holds units, not shares. It is equity-oriented only if it holds 90% or more in units of an exchange-traded fund that itself holds 90% or more in listed domestic equity. One that invests in an ordinary open-ended equity scheme falls in the third group.
What each group means for tax
For equity-oriented funds, units held 12 months or less give short-term gains taxed at 20% under section 196 of the Income-tax Act, 2025 (Section 111A of the old 1961 Act); units held more than 12 months give long-term gains taxed at 12.5% above ₹1.25 lakh a year under section 198 (old Section 112A).
For a specified mutual fund, gains on units bought on or after 1 April 2023 are taxed at the investor's slab rate whatever the holding period. For the third group, units held more than 24 months (more than 12 months if listed) give long-term gains taxed at 12.5% without indexation under section 197 (old Section 112); otherwise the slab rate applies. Surcharge, where it applies, and cess are added.
Rules at a glance
Three schemes, three groups (illustrative)
Scheme A holds 70% in listed shares of Indian companies and 30% in government bonds all year, so it is equity-oriented. Scheme B holds 20% in equity and 80% in debt and money-market instruments, so it is a specified mutual fund.
Scheme C holds 40% in equity and 60% in debt. Its debt is not more than 65% and its equity is below 65%, so it meets neither test and falls in the third group.
Measuring the 65% test over a year (illustrative)
- Assumed figures, for arithmetic only: a scheme's monthly average holding in listed domestic equity shares is 68% in each of ten months and 60% in each of the other two.
- Sum of the twelve monthly averages = (10 × 68) + (2 × 60) = 680 + 120 = 800.
- Annual average = 800 ÷ 12 = 66.67%, which is at least 65%.
- If the two lower months had been at 45%, the sum would be 680 + 90 = 770 and the annual average 770 ÷ 12 = 64.17%, below 65%.
Result. At 66.67% the scheme is equity-oriented for that year although two months were below 65%; at 64.17% it would not be.
Key points
- A scheme's tax group follows its actual holdings measured against tests in tax law, not its name.
- Equity-oriented means at least 65% in listed domestic equity shares, as the annual average of monthly averages.
- A specified mutual fund holds more than 65% in debt and money-market instruments.
- Arbitrage funds meet the equity test; a fund-of-funds does so only through the 90% exchange-traded fund route.
Common misunderstandings
- Hedging does not take an arbitrage fund out of the equity-oriented group: the fund still holds at least 65% in listed domestic equity shares.
- A fund with 60% in debt is not a specified mutual fund: the test is more than 65%.
- An international equity fund is not equity-oriented: the test counts only listed domestic equity shares.
Questions people ask
Is the 65% test applied on the day units are sold?
No. It is measured as the annual average of the monthly averages of the scheme's holdings.
Where do gold and silver funds fall?
In the third group, with hybrids between the two tests and international equity funds.
Does a liquid fund held for years get long-term treatment?
Not for units bought on or after 1 April 2023: the gain is taxed at the slab rate whatever the holding period.
What this lesson relies on
- Income-tax Act, 2025 — definitions of equity-oriented fund and specified mutual fund; sections 196, 197 and 198 on capital gains
- Fund-house tax reckoners for financial year 2026-27 (secondary source for rates and holding periods)
This lesson was reviewed independently against these sources on 8 October 2026. Rules change: check the current regulation, scheme document or policy wording before relying on any figure. This is education, not advice.