Chennai Tribunal Rejects Re-Characterisation Of Category II AIF’s Investment Income As Business Income, Affirms Tax Pass Through Status

The Chennai Bench of Income Tax Appellate Tribunal (Tribunal), in the case of Sundaram Alternative Opp Series High Yield Secured Debt Fund¹ (Fund) rejected the tax officer’s attempt to re-characterise the Fund's investment income as business income and affirmed the tax exemption for the Fund.

Background

• The Fund was set up as a contributory trust and duly registered with the Securities and Exchange Board of India as a Category II Alternative Investment Fund (AIF). As a background, a Category II AIF has been accorded tax pass through status with respect to its investment income i.e. the investment income is tax exempt for the AIF but taxed in the hands of the investors on a pass though basis. On the contrary, any business income is taxed at the AIF level at the applicable rate.
• In this case, the Fund earned interest income and certain processing fees (additional return) from its investment in the non-convertible debentures (NCDs) issued by the Indian companies, which was classed as “Income from other sources”. The Fund also earned income from sale of mutual fund units and characterised the same as “Capital Gains”. For all these income streams, the Fund claimed the tax exemption, as the income was taxable directly in the hands of the investors on a pass-through basis.
• However, the tax officer recharacterized the income as Profits and Gains from Business or Profession (Business Income) to levy tax in the hands of the Fund. This action was based on certain erroneous findings such as treating the fund as a Venture Capital Fund (as against a Category II AIF), misreading of the tax filings and inadvertently claiming that the Fund did not share information on its investment.
• Aggrieved by the tax officer’s position, the Fund preferred an appeal before the Commissioner of Income Tax (Appeals) (CIT(A)), who allowed the tax exemption claimed by the Fund, noting that the tax officer did not have any basis to recharacterize the income as Business Income.
• The tax department challenged the order of the CIT(A) before the Chennai Tribunal.

Tribunal Ruling

The Tribunal ruled in favour of the Fund, rejected the re-characterisation of investment income as Business Income and affirmed the tax exemption for the Fund. Key findings and observations of the Tribunal are as summarised below:

• The Tribunal categorically held that the tax officer proceeded on a fundamentally erroneous assumption of treating the Fund as a Venture Capital Fund.
• For the income to be treated as Business Income, the Fund must be engaged in a systematic and organized commercial venture with the dominant intention of earning trading profits rather than making investments. No such inference has been drawn by the tax officer.
• The tax officer did not apply settled judicial tests to determine the characterisation of income as Business Income or otherwise including the intention, frequency, volume, accounting treatment, source of funds and the AIF regulatory framework.
• The Fund had reported the securities as investments in its books of accounts and no leverage was permissible to make such investments.
• The tax officer’s finding that processing fee earned in relation to NCD assumes the nature of Business Income is incorrect as such fee was intrinsically connected to the investment in NCD and was in the nature of an additional return on the investment.

Comments

The ITAT ruling reinforces the distinction between investment income and business income in the context of Category II AIFs under the pass-through taxation regime. Notably, an amendment was introduced under the tax laws with effect from 1 April 2025 to treat the investment by a Category I or II AIF in any ‘securities’ (as defined under the Securities Contract (Regulation) Act, 1956), as ‘capital asset’ for tax purposes. This amendment puts an end to the controversy relating to characterisation of income from investment in securities. However, the Tribunal’s judgment shall serve as an important precedent for prior years, investment in assets that may not fall within the definition of ‘securities’ under the Securities Contract (Regulation) Act, 1956 as well as for Category III AIF engaged primarily in investment activities.

Footnote

1. TS-845-ITAT-2026(CHNY)

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