Why AIF Taxation Is Different From Ordinary Investment Vehicles Alternative Investment Funds sit in an unusual tax position in India: two of the three SEBI categories are taxed almost invisibly, while the third is taxed heavily at the fund level. Getting this wrong — at the PPM stage or in ongoing return filings — creates problems that are expensive to unwind later.
Pass-Through Taxation for Category I and Category II AIFs
Category I and Category II AIFs benefit from "pass-through" tax treatment under the Income-tax Act, 2025 (the provision continues the erstwhile section 115UB framework, now recast under the new Act). Under this regime: • Income earned by the fund — other than business income — is not taxed at the fund level. • It is instead taxed directly in the hands of investors, retaining the same character (capital gains, dividend, interest) it would have had if the investor had earned it directly. • The fund itself is taxed only on business income, generally at the maximum marginal rate.
What This Means Practically for Investors
An investor in a Category I/II AIF reports pass-through income under the relevant head (capital gains, interest, dividend) in their own return — not as a lump-sum "AIF income" — based on the statement the fund is required to issue annually.
How Category III AIFs Are Taxed Differently
Category III AIFs — funds using complex or leveraged trading strategies — do not get pass-through status. Income at the fund level is taxed in the hands of the fund itself (typically as an AOP, trust, or company depending on structure), generally at the maximum marginal rate, before any distribution to investors. This is one of the most common points of confusion for investors moving from a Category II to a Category III allocation, expecting the same tax treatment.
Treatment of Losses
Business losses at the fund level are carried forward and set off by the fund itself — they are not passed through to investors. Non-business losses can, subject to conditions (including a minimum holding period for the relevant units), be passed through to investors for set-off in their own hands.
Carried Interest and Its Tax Treatment
Carried interest received by the manager/sponsor is generally treated as capital gains where structured as a share of profits linked to the fund's investment performance, though the precise characterisation depends heavily on how the PPM and fund documents define the carry mechanism, and on judicial and CBDT positions that continue to evolve. This is an area where structuring advice before fund launch materially affects the eventual tax outcome.
Statement of Income Distributed
Funds are required to furnish a prescribed statement to each investor and to tax authorities annually, detailing the nature and quantum of income paid or credited — this is what allows investors to correctly report pass-through income (see our separate article on Form 64 for AIFs for the mechanics).
Cross-Border Considerations
Foreign investors are taxed based on the character of pass-through income and applicable DTAA relief, subject to FEMA compliance and the fund's withholding obligations.
Getting Your Fund's Tax Position Right From Day One
Tax outcomes for an AIF are substantially locked in by decisions made at the PPM and structuring stage — category selection, vehicle type (trust/LLP/company), and carry mechanics. Anuj Desai & Associates works with fund managers on tax-efficient structuring, ongoing compliance, and investor tax statements across the fund life cycle.
This article is for general informational purposes and does not constitute tax advice. Please consult us for guidance specific to your fund.