The finance ministry is considering a proposal to exempt "fund of funds" mutual funds from long-term capital gains in the forthcoming Budget.

These funds, which essentially invest in a clutch of fund schemes, allow retail and corporate investors to diversify their risk portfolio.

Currently, these funds are subject to long-term capital gains and dividend distribution tax, unlike equity mutual funds. The reason is that these funds - from the likes of Kotak Mutual Fund, Fidelity and Reliance Capital [Get Quote] among others - do not directly invest in the equity market.

The fund of funds schemes became unattractive on the tax front from 2004, when Finance Minister P Chidambaram provided long-term capital gains exemption to direct investments into the equity markets.

Therefore, the long-term capital gains tax exemption available to equity-oriented mutual funds (having over 50 per cent of their portfolio in equity) was not made applicable to these schemes.

"The government is considering placing the fund of funds schemes on par with other mutual fund schemes and removing the anomaly with regard to long-term capital gains tax," sources told Business Standard.

With the number of mutual fund schemes in the market going up, such funds will prove very useful to investors who want to diversify their investment across funds but find the tax treatment a barrier.

This and the dividend distribution tax meant that the fund of funds industry had not seen much action in the last one year barring some initial launches.

In anticipation of this anomaly being rectified some fund houses have filed offer documents with Securities and Exchange Board of India.