Decoding The Alternative Investment Funds Tax Puzzle In India: A Category-Wise Analysis

"In this world, nothing is certain except death and taxes."- Benjamin Franklin

For Alternative Investment Funds (AIFs) in India, the second certainty often proves more complex than the first.

Over the past decade, India's tax framework for AIFs regulated under the SEBI (Alternative Investment Funds) Regulations, 2012 has evolved significantly. The Finance Act, 2015 introduced section 115UB, establishing a statutory pass-through regime for Category I and II AIFs. More recently, the Finance Act, 2025 has clarified the capital gains treatment of securities held by these funds by amending section 2(14) of the Income-tax Act (IT Act). The amendment provides that securities held by an "investment fund" referred to in section 115UB are to be regarded as capital assets for the purposes of the Act. As a result, gains arising from the transfer of such securities are to be treated as capital gains rather than business income. At the same time, judicial interpretation has shaped how the Maximum Marginal Rate (MMR) applies to Category III AIFs, particularly where different streams of income are involved.

As a result, the taxation of AIFs is not governed by a single rule. Instead, tax outcomes depend on a combination of factors such as the category of the fund, the legal structure in which it is established, and the nature of the income generated. Category I and II AIFs largely operate under a pass-through framework, where most income is taxed directly in the hands of investors. Category III AIFs, by contrast, are generally taxed at the fund level, and their tax treatment varies depending on whether the fund is structured as a trust, company, or LLP.

This article distils the framework into practical terms by outlining who is taxed, at what level, on which income streams, and where the framework still has structural gaps. By bringing together statutory provisions, recent legislative changes, and judicial interpretation, the article aims to provide a clear guide to how AIF taxation currently operates in India and the structural issues that fund managers and investors must navigate.

What is an Alternative Investment Fund and how are AIFs categorised for tax purposes?

An Alternative Investment Fund (AIF) is a SEBI-registered pooled investment vehicle that raises capital from investors and invests according to a stated strategy. AIFs are regulated under the SEBI (Alternative Investment Funds) Regulations, 2012. As a general rule, the minimum investment per investor is ?1 crore and the minimum corpus per scheme is ?20 crore.

For tax purposes, the categorisation of an AIF under the AIF Regulations is the single most consequential variable in determining the applicable tax framework. The three categories are:

• Category I AIFs (Regulation 3(4)(a)): Funds that invest in start-ups, early-stage ventures, SMEs, social ventures, and infrastructure projects (for example, venture capital and infrastructure funds). These funds generally take longer-term positions, often in unlisted securities.
• Category II AIFs (Regulation 3(4)(b)): Funds that do not fall under Category I or III and do not use leverage except for operational needs. This category includes private equity, real estate, credit, and distressed asset funds.
• Category III AIFs (Regulation 3(4)(c)): Funds that employ diverse or complex trading strategies and may use leverage, including through investment in listed or unlisted derivatives including hedge funds and PIPE funds.

This classification is not merely regulatory; it directly determines how an AIF is taxed under the IT Act. Category I and II AIFs benefit from the statutory pass-through regime under section 115UB, whereas Category III AIFs are generally taxed at the fund level under the normal provisions of the Act. Understanding this distinction is therefore essential before examining the tax treatment applicable to each category.

CATEGORY I AND II AIFS: PASS-THROUGH REGIME

Now, before examining how the pass-through regime functions for Category I and II AIFs, it is useful to briefly understand what "pass-through" means in the context of taxation.

In a pass-through structure, the investment vehicle itself is generally not taxed on the income it earns. Instead, the income is treated as if it were earned directly by the investors and is taxed in their hands. The fund therefore acts primarily as a conduit, passing income through to investors while preserving its original character for tax purposes.

How does the pass-through regime work for Category I and II AIFs?

The pass-through regime operates through a three-part mechanism under the IT Act:

• Under section 10 (23FBA), the fund itself is exempt from tax on all income except business income (Profits and Gains of Business or Profession or PGBP).
• Under section 115UB(1), the income referred to in section 10(23FBA) is taxed directly in the hands of investors as if they had made the underlying investments themselves. The nature of income is preserved; capital gains remain capital gains, interest remains interest.
• 
  Under section 10(23FBB), income already taxed at the fund level (i.e., business income) is not taxed again in the hands of investors.

In effect, a Category I or II AIF is tax-transparent for non-business income. Investors are taxed at their own applicable rates and may claim treaty benefits and exemptions available to them.

What is the tax treatment of business income earned by a Category I or II AIF?

If a Category I or II AIF earns income that is characterised as business income (PGBP), the fund itself is taxed on that income. Investors are not taxed again on such income under section 10(23FBB). The rate of tax depends on the legal structure of the AIF, as summarised below (AY 2025–26):

Under section 115UB (4), this is the only category of income on which a Category I or II AIF is taxed at the fund level.

While the pass-through regime largely ensures that income flows through the fund to investors, the treatment of losses operates differently. The law does not permit all losses to be passed through in the same manner as income. Instead, section 115UB(2) prescribes specific conditions that determine whether a loss remains at the fund level or can be allocated to investors. Understanding this distinction is important, particularly for investors participating in funds with longer holding periods or volatile strategies.

Section 115UB (2) introduces an asymmetric treatment of losses:

• Business losses remain at the fund level and may be carried forward only against the fund's future business income. They are not passed through to investors.
• Losses under other heads of income may be passed through to investors only if the investor has held the units of the AIF for at least 12 months at the end of the relevant previous year.

As a result, investors in short-duration strategies or those who exit before completing 12 months cannot benefit from the fund's non-business losses. In practical terms, business losses remain with the fund, while non-business losses are available to investors only if the statutory holding-period condition is satisfied.

CATEGORY III AIFS: FUND-LEVEL TAXATION

How is a Category III AIF taxed at the fund level?

Category III AIFs operate under a fundamentally different tax framework from Category I and II funds. They are expressly excluded from the pass-through regime under section 115UB of the IT Act. As a result, the income earned by a Category III AIF is generally taxed at the fund level under the ordinary charging provisions of the Act, with the fund itself treated as the primary taxable person.

The tax outcome for a Category III AIF is therefore not driven by a statutory pass-through rule, but by two key factors that are as follows:

• the legal form of the fund (trust, company, or LLP) and
• nature of income generated by the fund, such as business income, capital gains, or other income streams.

These variables together determine how the income is assessed and the rate at which it is taxed.

In practice, most Category III AIFs are structured as private irrevocable trusts, which are governed by the representative assessee framework under sections 160 to 164 of the Income-tax Act. However, Category III funds may also be established as companies or LLPs, each of which follows a different tax treatment under the Act. The tax implications of these alternative structures are discussed below, followed by a comparative overview of the trust, company, and LLP models.

How is a Category III AIF structured as a trust taxed? What is the significance of the determinate / indeterminate distinction?

Where a Category III AIF is structured as a trust, it is assessed under sections 160–164 of the IT Act, with the trustee taxed as a representative assessee. The decisive issue is whether the trust is determinate or indeterminate. A trust is determinate if the beneficiaries are identifiable and their shares are ascertainable; it is indeterminate if either the beneficiaries or their shares are indeterminate or unknown, in which case section 164(1) attracts taxation at the MMR.

In Equity Intelligence AIF Trust v. CBDT & Anr., (2025: DHC: 6170-DB), the Hon'ble Delhi High Court held that a Category III AIF does not become indeterminate merely because investor names are absent from the original trust deed. The Hon'ble Court undertook a conjoint reading of Regulations 3, 4, 6 and 7 of the SEBI (AIF) Regulations, 2012 and section 12 of the SEBI Act, and noted that no entity can act as an AIF or accept monies unless registered with SEBI. Since registration requires a settled trust deed prior to fundraising, it is legally impossible to name investors at inception. Applying the maxim lex non cogit ad impossibilia, the Hon'ble Court read down CBDT Circular No. 13/2014 and held that the absence of investor names at inception cannot, by itself, trigger section 164.

In reaching this conclusion, the Hon'ble Delhi High Court relied on earlier judicial authorities addressing the determinacy of beneficiary interests in investment fund structures. It followed CIT v. India Advantage Fund-VII (2017 SCC OnLine Kar 6857) and CIT v. TVS Shriram Growth Fund (2020 SCC OnLine Mad 28112), which in turn relied on CIT v. P. Sekar Trust (321 ITR 305, Mad.). These decisions affirm that the decisive test is whether the beneficiaries' shares are determinable, such as where benefits are allocated proportionately to unit holdings, rather than whether beneficiaries are expressly named in the original trust deed. Accordingly, a unit-based AIF trust with ascertainable proportional rights qualifies as a determinate trust for the purposes of section 164. Once this determinacy is established, the next question is how the income of such a trust is taxed, particularly whether the MMR under section 161(1A) applies to all income of the trust or only to its business income.

Does the MMR under section 161(1A) apply to all income of a Category III AIF trust, or only to business income?

A critical issue for Category III AIF trusts is whether the MMR under section 161(1A) applies to the entire income of the trust or only to its business income. The correct position is that section 161(1A) applies only to income in the nature of PGBP, not to all income of the trust.

Section 161(1A) begins with the words "notwithstanding anything contained in sub-section (1)". It does not override the entire Act. In CIT v. T.A.V. Trust (264 ITR 52), the Hon'ble Kerala High Court held that where a determinate trust earns both business income and non-business income, MMR applies only to the business income. Other income continues to be taxed under section 161(1), i.e., in the same manner and to the same extent as it would have been taxed in the hands of the beneficiaries.

The Hon'ble Court clarified that "the income so liable" in section 161(1A) refers only to business income. Extending MMR to all income, regardless of character, would distort the scheme of sections 160–164.

For Category III AIFs running mixed strategies, this distinction is commercially significant. Derivative or trading income, treated as PGBP, is taxable at MMR under section 161(1A). However, capital gains on investment positions, dividend income, and non-business interest are assessed under section 161(1) at the rate applicable to the beneficiaries. A fund combining futures and options with long-term equity investments therefore does not automatically suffer a uniform MMR on all income; only the business component attracts that rate.

How is a Category III AIF structured as a company taxed?

Where a Category III AIF is set up as a company, it is taxed under the normal corporate tax regime. The trust-specific provisions in sections 160–164 do not apply. The key advantage is certainty; there is no MMR exposure, and taxation follows standard corporate principles.

For AY 2025–26, domestic companies may opt for 22% under section 115BAA (subject to conditions), 25% if turnover thresholds are met, or otherwise 30% (plus surcharge and cess). Minimum Alternate Tax under section 115JB applies at 15% of book profits where the company is taxed under the normal regime; it does not apply to companies opting for sections 115BAA or 115BAB.

The principal disadvantage of this structure is economic inefficiency, as profits are taxed at the company level and distributions to investors may result in a second layer of tax depending on the mode of extraction. This generally makes the company structure less tax-efficient in comparison to a trust, unless structural or commercial considerations justify it.

How is a Category III AIF structured as an LLP taxed?

If a Category III AIF is structured as an LLP, it is taxed under the firm/LLP regime. The LLP pays tax at 30% (plus surcharge and cess), and Alternate Minimum Tax under section 115JC applies at 18.5% where normal tax is lower.

Unlike a company, an LLP does not face two-layer taxation. Once the LLP pays tax, distributions of profit to partners are exempt in their hands under section 10(2A). This single-level taxation is more efficient than the corporate structure. However, from 1 April 2025, section 194T requires LLPs to deduct TDS at 10% on specified payments to partners (such as interest or remuneration) exceeding the prescribed threshold; profit shares themselves are not subject to this TDS.

Despite the tax efficiency, LLP structures are less preferred for floating Category III AIFs. This framework does not align well with unit-based fund structures. Admission of new investors typically requires amendments to the LLP agreement, creating operational friction in open or close ended funds. Institutional and foreign investors also tend to prefer trust structure. In practice, the limited use of LLP structures for Category III AIFs is mainly due to acceptability and governance concerns rather than tax reasons.

How do the trust, company, and LLP vehicles compare for AIF taxation purposes?

A comparative summary of the key tax features across Category I & II and Category III AIF structures is set out below:

THE BOTTOM LINE

AIF taxation turns first on category. Section 115UB creates a clear divide: Category I and II AIFs operate under a statutory pass-through regime, while Category III AIFs are taxed at the fund level. Most structuring decisions flow from this distinction.

For Category I and II AIFs, non-business income is exempt at the fund level and taxed directly in investors' hands with character preserved. Business income alone is taxed at the fund level. From April 1, 2026, onwards, the Finance Act, 2025 strengthens this framework by amending section 2(14) to recognise securities held by such funds as capital assets. For earlier years, capital gains treatment continues to depend on the CBDT circular framework and consistent factual conduct.

Category III AIFs require closer structural scrutiny. Where constituted as trusts, taxation depends on determinacy under sections 160–164. Absence of investor names at inception does not, by itself, render an AIF trust indeterminate if beneficiary shares are ascertainable, as affirmed in Equity Intelligence AIF Trust v. CBDT (2025: DHC: 6170-DB). Further, under CIT v. T.A.V. Trust (264 ITR 52), the MMR under section 161(1A) applies only to business income, not to the entire income of a determinate trust.

Vehicle selection for Category III involves trade-offs: companies provide certainty but create two-layer taxation; LLPs allow single-level taxation under section 10(2A) but face practical acceptance constraints; trusts remain the dominant structure.

Finally, certain structural gaps still persist in the AIF tax framework. The loss pass-through rules for Category I and II AIFs are asymmetric, as business losses remain at the fund level while non-business losses pass through only if investors satisfy the prescribed holding period. In Category III funds, redemption of units can give rise to capital gains in the hands of investors even though the fund may already have paid tax on the underlying income, with no statutory mechanism allowing credit for such taxes. Careful structuring, documentation, and consistent characterisation of income therefore remain essential.

All tax rates and statutory references in this article are as applicable for the relevant assessment year discussed. Readers should verify subsequent amendments, as tax laws and rates are subject to change.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.