As liquid funds park their assets in debt instruments, they get the same tax treatment as debt funds.
In debt funds, the capital gains are taxed according to your holding period, or the period for which you have been invested in the fund.
If you have been invested in the fund for less than three years, then the returns will attract short-term capital gains (STCG) tax. STCG from debt funds are added to the investor’s income and taxed according to his income slab.
However, if you’ve been invested in the fund for over three years then the returns will attract long-term capital gains (LTCG) tax. LTCG from debt funds is taxed at 20% after the indexation benefit and 10% without the benefit of indexation.
Of course, it makes sense to invest in liquid funds as they earn relatively higher returns for you than what your idle cash, lying in the bank accounts, will. It’s like putting your money to work with the added advantage of being able to access it as and when you want.