Saturday, January 14, 2012

Tax on Capital protection funds

A capital protection-oriented fund is a closed-ended debt scheme of a mutual fund. The fund manager invests money in both equity and fixed income instruments in a pre-determined ratio.

Most of your money is invested in high quality fixed income instruments that are expected to mature in sync with the end of the scheme tenure.

High quality fixed income instruments include instruments with high ratings that imply low possibility of default.
This ensures that by the end of the scheme term, the money invested in these instruments grows to the original sum invested in the capital protection-oriented fund. Rest of the money is invested in equity.

To understand it better, let us take an example. Suppose `1 lakh is invested in a capital protection fund with a three-year tenure.

If the fund manager comes across instruments of high credit quality with the least possibility of default, offering 8% return per year, he would invest approximately 80% of the money into a portfolio of such instruments.

This will ensure that this money will grow to `1 lakh at the end of the tenure and you are assured of getting your money back. The remaining 20% of the money in this case is invested in equity. While fixed income instruments assure your capital back, equity brings in the much needed returns.

Put simply, the performance of the capital protection-oriented funds will depend on the fund manager’s ability to choose the right calls in equity.

A point to note is that the fund does not guarantee your capital. In extreme situations, if the issuers of the high quality fixed income instruments default, a scheme may show capital loss.

Normally, if the investor remains invested till maturity of the scheme, he is likely to get the capital back along with returns generated by equity.

Units of the capital protection oriented scheme are listed on the stock exchanges. However, they are rarely traded on the stock exchanges offering little liquidity to the investor.

Capital protection oriented funds are taxed like a debt mutual fund , where long-term capital gains are taxed at 10.3% without indexation or 20.6% with indexation, whichever is lower.

Source: Economic Times

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