Table of Contents
- What Are AIFs?
- Categories of AIFs
- ✅ Category I AIFs
- ✅ Category II AIFs
- ✅ Category III AIF
- Why Does AIF Taxation Matter?
- Resident Investors
- Non-Resident Investors
- Taxation of AIFs in India
- 🟢 Category I & II AIFs – Pass-Through Status
- 🟠 Category III AIFs – No Pass-Through
- What Is Construed as "Business Income" under AIFs?
- Withholding Tax (TDS)
- An Example in a Category II AIF
- 💡Key Takeaways
Do not index
Do not index
Alternative Investment Funds (AIFs) have become a popular choice for high-net-worth investors looking to diversify beyond traditional assets like stocks and mutual funds. But before investing, it's crucial to understand how AIFs are taxed in India.
Let’s break it down in simple terms.
What Are AIFs?
AIFs are specialised investment vehicles catering to high-net-worth investors with unique investment requirements.
Unlike traditional investment options, AIFs are pooled investment vehicles.
They invest in a diverse range of alternative assets, including
- Hedge Funds
- Private Equity
- Venture Capital
- Angel Funds, and
- Real Estate Investment Trusts (REITs).
They are governed by SEBI under the SEBI (Alternative Investment Funds) Regulations, 2012, and can be structured as trusts, LLPs, companies, or corporate bodies.
Categories of AIFs
AIFs in India are divided into three categories:
✅ Category I AIFs
AIFs which invest in
- Start-up or early stage ventures
- Social ventures
- SMEs
- Infrastructure
- Other sectors or areas which the government or regulators consider as socially or economically desirable, and
- Other Alternative Investment Funds
✅ Category II AIFs
- AIFs which do not fall in Category I and III, and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements and as permitted by SEBI
- Invest in private equity, real estate, debt, and distressed assets. These funds don’t use leverage or complex strategies.
✅ Category III AIF
- AIFs which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives.
- These funds aim for short-term gains using strategies like derivatives and leverage. Examples: hedge funds, long-short funds, PIPE funds.
Why Does AIF Taxation Matter?
AIF Taxation matters because tax rules vary by AIF category and the type of income (capital gains, interest, business income, etc.). There are also differences in how resident and non-resident investors are taxed. They are:
Resident Investors
- Taxed as per the Indian Income Tax Act.
- Required to file tax returns and report income from AIFs.
- Eligible for indexation, DTAA (Double Taxation Avoidance Agreement) relief if investing overseas via Category I or II.
Non-Resident Investors
- TDS (Tax Deducted at Source) is applicable on distributed income.
- Can avail benefit of DTAA, reducing tax liability on interest or capital gains.
- In some cases, AIFs need to file income on behalf of NRIs.
- Additional compliance requirements (e.g., Form 10F, TRC).
Taxation of AIFs in India
🟢 Category I & II AIFs – Pass-Through Status
These AIFs enjoy pass-through taxation. That means:
- Capital gains and other investment income are not taxed at the fund level.
- The income is taxed in the hands of investors, based on their tax slab or applicable rate.
But there's one exception:
Business income (like trading or lending interest) is taxed at the AIF level at 30% + surcharge + cess.
🟠 Category III AIFs – No Pass-Through
These AIFs do not enjoy pass-through status. All income (capital gains, dividends, business income) is taxed at the fund level.
Fund-Level Tax Rates:
Income Type | Tax Rate (Fund Level) |
Long-term capital gains | 10% + surcharge + cess |
Short-term capital gains | 15% + surcharge + cess |
Business & dividend income | 30% + surcharge + cess |
Investors are usually not taxed again on this income when it is distributed to them.
What Is Construed as "Business Income" under AIFs?
Business income refers to money earned by doing business-like activities. AIFs may earn this type of income in these situations:
- Frequent Trading - Buying and selling securities very often, like a trader - not holding them for long-term investment.
- Lending Activities - If an AIF lends money to companies and earns interest, this interest is treated as business income.
- Active Operations - If the AIF is doing active business, like offering consulting or managing assets aggressively, the income from those activities is business income.
Key Difference:
Type of Income | Example | Taxed Where | Tax Rate |
Capital Gains | Buying and holding shares | Investor’s hands | 10% or 20% |
Business Income | Interest, short-term trades, lending | Fund level | 30% + surcharge |
Withholding Tax (TDS)
AIFs must deduct TDS before distributing income:
- Residents: 10% TDS on investment income (except business income)
- Non-residents: Lower of Income Tax Act rate or DTAA rate
An Example in a Category II AIF
Mr. X invests ₹1 crore in a Category II AIF. The fund earns:
- ₹10 lakh in long-term capital gains
- ₹5 lakh in business income
Tax Outcome:
- ₹10 lakh LTCG → Taxed in Mr. X’s hands @ 10% or 20%, depending on asset
- ₹5 lakh business income → Taxed at AIF level @ 30% + surcharge
Mr. X won’t pay tax on that ₹5 lakh again – it’s already taxed by the fund.
💡Key Takeaways
- Category I & II AIFs: Pass-through for capital gains/investment income; business income taxed at fund level.
- Category III AIFs: All income taxed at the fund level.
- From FY 2026: Investors in Cat I & II AIFs will pay a flat 12.5% capital gains tax.
- Business income is taxed differently and should be understood before investing.
AIFs can offer attractive returns and portfolio diversification – but understanding their taxation is essential.
Since taxation depends on both the category and the type of income, it’s wise to consult a financial or tax advisor before investing.