Budget changes: Why seasoned investors may want to look into gold, silver and foreign ETFs

Budget 2024 has changed the investment landscape, making ETFs much more attractive compared to funds of funds (FOFs). With changes in taxation of gold, silver and foreign investments, ETFs now offer a compelling advantage with shorter holding periods and trading flexibility.

Previously, investments in ETFs and FoFs were subject to separate tax rules, but the new rules have streamlined them, creating a more favorable environment for ETFs. This change not only shortens the time it takes to benefit from long-term capital gains (LTCG) but also increases the convenience of trading, positioning ETFs as the preferred choice for experienced investors looking to optimize their portfolios.

ETFs are bought and sold through stock exchanges and held in demat accounts. On the other hand, FOFs are held in the form of a statement of account (with registrar and transfer agents, or RTAs) and are bought directly from asset management companies (AMCs) and redeemed directly with the AMCs.

Old vs. New Regime

ETFs: Before April 1, 2023, investments in gold, silver, and foreign ETFs were subject to LTCG if held for more than 36 months — taxed at 20% with indexation benefits. Short-term capital gains (STCG) on these ETFs were taxed at the investor’s applicable income tax rate.

FoFs: Commodity (gold and silver) mutual funds and offshore funds were subject to similar tax rules but were classified differently.

Budget 2023 redefined the taxation rules and holding periods for these investment vehicles, making them taxable at the basic rate. It provided cover for investments made before April 2023, enabling them to avail the 20% index-linked benefit.

However, the Budget 2024-25 introduced another change. For redemptions made after March 31, 2025, the holding period for calculating capital gains has been standardized to 24 months. This adjustment brings the treatment of these instruments in line with other assets but gives ETFs an advantage over FoFs due to the reduced holding period.

Both ETFs and FoFs are taxed at a rate calculated 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 as they are listed securities, while for FoFs it is 24 months.

Advantages of ETFs over FoFs

With the same tax treatment but different holding periods, ETFs now represent a more attractive option for investors. The benefits of choosing ETFs over FoFs are multi-faceted.

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 attractive option for investors looking to optimize their tax obligations. So, if you hold a Gold ETF for just over a year, you will enjoy a LTCG tax rate of 12.5%. In the case of FoFs, you would have to wait two full years for this benefit. This is a clear win for ETFs in terms of tax efficiency.

While both ETFs and FoFs are subject to similar taxation under the new regime — basic rate for STCG and 20% with indexation benefits for LTCG — the shorter holding period of ETFs means investors can benefit from the lower tax rate on LTCG earlier.

In addition, ETFs offer the convenience of trading because they are traded on exchanges, which allows 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 example, if you need to liquidate an ETF quickly, you can do so at any time during market hours. With FoFs, you would have to wait until the end of the day to make your move.

Additionally, ETFs tend to have lower expense ratios compared to FOFs, making them a more cost-effective choice for long-term investors. This is another area where ETFs excel. ETFs typically have lower expense ratios because they passively track an index and don’t require active management. FOFs, however, tend to incur higher fees due to the added layer of fund management.

In addition, ETFs provide targeted exposure to specific sectors, commodities or international markets, allowing you to tailor your portfolio to your specific needs. If you want to invest specifically in international technology stocks, for example, there is an ETF for that purpose. However, an FOF can give you broader exposure across multiple sectors, which may not align with your focused investment strategy.

However, investing in ETFs requires a demat account, which may not be necessary in the case of FOFs. This requirement may be a barrier for some investors who are not familiar with stock market operations or prefer the simplicity of investing through mutual funds.

Note: For equity ETFs and FOFs investing in equity funds (more than 65% in equities and more than 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 holding period of 12 months for long-term classification.

In contrast, pure debt ETFs and FoFs with significant investments in debt and money market instruments are taxed at the minimum rate, irrespective of the holding period, under section 50AA of the Income Tax Act 1961.

Application

The new tax regime favours ETFs over FOFs for asset classes such as gold and foreign equities, mainly due to the shorter holding period required to benefit from LTCG tax rates.

This advantage, combined with the benefits inherent to ETFs such as liquidity, lower costs and trading flexibility, is making them an increasingly attractive option for investors in gold, silver and offshore markets.