Taxation of AIFs Explained

In a pass-through structure, the fund itself is not taxed on the income it earns. Instead, that income "passes through" to investors, retaining its original character (capital gains, dividend, interest, etc.), and is taxed directly in the hands of each investor at their applicable rate.

This is the opposite of fund-level taxation, where the fund pays tax on its income first, and investors receive only the post-tax amount as a distribution — with no further tax liability on that distribution.

Under the Income Tax Act, this treatment is governed primarily by Section 115UB, and the specific tax treatment differs sharply across the three SEBI-defined AIF categories.

Powered by Froala Editor

Category I AIFs (venture capital, SME, social impact, infrastructure funds) and Category II AIFs (private equity, private credit, real estate, and other funds that don't use leverage beyond permitted operational limits) enjoy pass-through status under Section 115UB.

In practice, this means:

• Capital gains, dividend income, and interest income earned by the fund are not taxed at the fund level. They flow through to investors and are taxed in their hands, retaining their original character.

• Long-term capital gains (LTCG) on listed securities, for instance, are taxed at 12.5% beyond ₹1 lakh in an investor's hands (post Finance Act 2024), just as they would be if the investor held the security directly.

• The one major exception: business income. If the fund's activity is classified as a trading or business activity (as opposed to investment activity), that income is taxed at the fund level, typically at the Maximum Marginal Rate (MMR), before it ever reaches investors.

This means even "pass-through" Category I and II funds aren't entirely free of fund-level tax — the character of the income earned still matters.

Powered by Froala Editor

This is where most of the confusion lies. Category III AIFs — funds employing diverse or complex strategies, often including derivatives, leverage, and both listed and unlisted exposures (hedge funds, long-short funds, multi-strategy funds) — do not get pass-through treatment. The fund is taxed at the fund level, and investors receive distributions net of tax, with no further income tax liability on those distributions.

However, "taxed at the fund level" does not automatically mean "taxed at a flat 42.74% MMR on everything." The actual rate depends on how each stream of income is characterized:

• Business income (PGBP) — typically derivative trading, F&O positions, or short-term trading activity classified as a business — is taxed at the fund level at the Maximum Marginal Rate, roughly 42.74% under the old regime (30% base + 37% surcharge + 4% cess), under Section 161(1A).

• Capital gains, dividend income, and non-business interest, by contrast, are assessed under Section 161(1) and are not automatically subject to MMR. Where the fund is structured as a determinate trust, these income streams can be taxed at the applicable capital gains/beneficiary rate — not MMR.

This distinction was significantly clarified by the Delhi High Court in Equity Intelligence AIF Trust v. CBDT (July 2025), which confirmed that determinate trusts may apply concessional, income-type-specific rates on eligible capital gains, rather than a blanket MMR across all income. Prior to this, many funds conservatively withheld tax at MMR on their entire income pool, which — post-ruling — may have resulted in over-withholding for some structures.

For indeterminate trusts, however, MMR can still apply more broadly across the fund's entire income, since the beneficiaries' shares aren't clearly ascertainable at the outset.

If the Fund Is Structured as a Company

Some Category III AIFs are structured as companies rather than trusts. In that case, the trust-specific provisions of Sections 160–164 don't apply at all. The fund is taxed under the standard corporate tax regime — with no MMR exposure and no ambiguity around determinate/indeterminate status. This offers more certainty, though the applicable corporate rate itself may be higher or lower than MMR depending on the specific circumstances.

Powered by Froala Editor

The difference between pass-through and fund-level taxation isn't a technicality — it can materially change your realized returns.

Consider a Category III fund reporting a 15% gross IRR. If a significant portion of that return is generated through active trading (business income) inside an indeterminate trust structure, fund-level tax at MMR can reduce that 15% gross figure to roughly 9–10% post-tax by the time it reaches you. The same fund, if structured as a determinate trust with genuine investment-style capital gains dominating the return, would retain considerably more of that headline return after tax.

This is precisely why comparing AIFs — or comparing an AIF to a PMS (Portfolio Management Service) — purely on gross, pre-tax IRR can be misleading. Two funds with identical gross returns can deliver very different amounts in an investor's pocket, depending on:

1. AIF Category (I, II, or III)

2. Legal structure (trust — determinate or indeterminate — LLP, or company)

3. Income composition (capital gains vs. business/trading income)

4. Investor profile (resident, NRI, HNI, corporate, or trust)

Key Takeaways for Investors

• Category I & II funds are largely pass-through, except for business income, which is taxed at the fund level.

• Category III funds are taxed at the fund level on all income — but not uniformly at MMR. Business/trading income attracts MMR; genuine capital gains (in determinate trust structures) can be taxed at applicable capital gains rates instead.

• The legal structure of the fund — trust (determinate vs. indeterminate), LLP, or company — has a direct bearing on the effective tax rate, sometimes as significant as the AIF category itself.

• Always evaluate a fund on post-tax, post-fee returns, not headline gross IRR — and confirm the specific tax treatment from the fund's Private Placement Memorandum (PPM), trust deed, and tax notes rather than relying on general category-level assumptions.

Powered by Froala Editor

AIF taxation sits at the intersection of income tax law, trust law, and evolving judicial interpretation — and it continues to develop, as seen with the 2025 Equity Intelligence ruling. What applies to one fund's structure may not apply identically to another, even within the same AIF category. Investors are strongly encouraged to consult a qualified tax advisor and review fund-specific documentation before drawing conclusions about expected post-tax returns.

This article is for informational purposes only and does not constitute tax or investment advice.

Powered by Froala Editor