AIF Taxation in India - Complete Guide for Investors

Why AIF Taxation Matters

When evaluating an Alternative Investment Fund (AIF), most investors focus on the fund’s strategy, past performance, and management team. But taxation can make a significant difference to your actual take-home returns.

Two AIFs with identical gross returns can leave you with very different amounts after taxes - depending on:

• How income is classified (capital gains, interest, business income, etc.)
• Whether the fund is a “pass-through” entity or taxed at the fund level
• Your personal tax slab and residential status (Resident or NRI)
• Applicable surcharges, cess, and withholding tax rules

For High Net Worth Individuals (HNIs), ignoring tax efficiency can erode returns by several percentage points annually. Since AIF investments typically have long lock-ins, understanding the tax framework upfront helps you:

• Choose the right category of AIF aligned to your post-tax objectives
• Avoid unpleasant surprises when distributions start
• Structure your investments for better efficiency (especially for NRIs with DTAA benefits)

Tax Framework Basics for AIFs in India

AIFs in India are governed by the SEBI (Alternative Investment Funds) Regulations, 2012. From a tax perspective, there are two broad ways AIF income is treated:

a) Pass-Through Structure

• The fund itself is not taxed on certain types of income.
• Instead, income is directly taxed in the hands of investors, in proportion to their share.
• Category I and Category II AIFs enjoy a pass-through status only for capital gains.
• Other income (e.g., business income) is taxed at the fund level.

b) Taxed at Fund Level

• All income is taxed within the AIF before distribution to investors.
• Category III AIFs (and certain Category I/II income types) fall under this structure.
• The investor receives post-tax distributions and is not taxed again on the same amount in India (though they must report it in their tax filings).

c) Reporting & Compliance

Regardless of the structure:

• AIFs must file detailed statements with investors and the Income Tax Department (Forms 64C and 64D).
• Investors need to include their share of income in their own ITRs.
• TDS (Tax Deducted at Source) applies differently for residents and NRIs, and rate varies by income type.

Category-wise Taxation of AIFs in India

The taxation of AIFs depends heavily on which category you invest in, as defined by SEBI. Here’s how each is treated under Indian tax laws:

Key Takeaways:

• For Category I & II, capital gains retain their nature when passed through to investors - meaning LTCG on equity (10% beyond ₹1 lakh) and STCG (15%) rules apply.
• For Category III, investors have no say in tax optimisation at their own slab - what you get is after the fund’s tax outgo.
• NRIs must consider Double Taxation Avoidance Agreements (DTAA) to reduce withholding tax and avoid being taxed twice.

How Different Income Types Are Taxed in AIFs

When you invest in an AIF, your returns can come from multiple income sources - and each is taxed differently. Understanding this breakdown helps you avoid surprises at payout time.

a) Capital Gains

• Long-Term Capital Gains (LTCG):
  • On equity-oriented assets: 10% on gains above ₹1 lakh (holding period >12 months).
  • On debt-oriented assets: 20% with indexation benefits (holding period >36 months).
• Short-Term Capital Gains (STCG):
  • On equity: 15% (holding ≤12 months).
  • On debt: Taxed at your slab rate.

For Category I & II AIFs, capital gains are passed through to investors, meaning you report them in your own tax return.

b) Interest Income

• For Category I & II AIFs, interest earned (e.g., from debt instruments) is generally passed through and taxed in the investor’s hands at their applicable slab rate; the fund itself is not taxed on this income.
• For Category III AIFs, interest income is typically treated as business income and taxed at the fund level. Investors receive post-tax distributions and are not taxed again on that interest.

Note: All tax rates mentioned are exclusive of applicable surcharge and cess. NRIs may be eligible for lower rates or relief under the Double Taxation Avoidance Agreement (DTAA) between India and their country of residence.

c) Business Income

• Primarily relevant for Category III AIFs that trade frequently or use derivatives.
• All such income is taxed as business income at the fund level at the maximum marginal rate (MMR), currently ~42.744% for individuals.
• Investors receive only the net-of-tax distribution.

Why This Matters for Portfolio Planning

• If you’re in a high personal tax bracket, Category I & II may still be attractive due to pass-through capital gains treatment.
• Category III might suit those prioritising absolute returns over tax efficiency.
• NRIs should assess withholding tax (TDS) and explore DTAA benefits with their country of residence.

Tax Compliance & Reporting for Investors (Resident & NRI)

AIF investments don’t just require capital - they require accurate reporting to avoid penalties. Your obligations differ slightly depending on whether you’re a Resident Indian or an NRI.

a) For Resident Investors

1. Include Pass-Through Income in ITR
   • For Category I & II AIFs, capital gains and other pass-through income must be declared in the relevant schedules of your Income Tax Return (ITR).
   • Even if the fund deducts TDS, you must still report the gross amount.
2. Maintain Documentation
   • Annual Statement of Account from the AIF.
   • Form 64C: Statement of income distributed by the fund.
   • Contract notes or proof of investment for audit purposes.
3. Advance Tax
   • If your tax liability exceeds ₹10,000 in a year, you must pay advance tax in four instalments to avoid interest penalties.

b) For NRI Investors

1. TDS on Distributions
   • AIFs deduct TDS before making payouts to NRIs - rates depend on income type (e.g., LTCG, STCG, interest, business income).
   • Check whether Double Taxation Avoidance Agreement (DTAA) benefits apply with your country of residence to reduce withholding.
2. Form 64C & 64D
   • Form 64C: Sent to investors showing income distributed and taxes withheld.
   • Form 64D: Filed by the AIF with the tax department.
3. Filing ITR in India
   • Even with TDS deducted, most NRIs must file an ITR in India if they have taxable income here.
   • Use the NRI-specific ITR form (ITR-2) unless you have business income (then ITR-3).
4. Repatriation Compliance
   • If you plan to remit gains abroad, ensure you comply with RBI’s FEMA regulations and bank documentation (Form 15CA/15CB).

Practical Tax Planning Tips for AIF Investors

Tax efficiency can significantly improve your net returns from AIF investments - especially since most investors here fall into higher tax brackets.

1. Match Category Choice to Tax Profile

• Category I & II AIFs: Pass-through status means taxes are levied at your slab rate (for interest, STCG) or applicable capital gains rate.
  • Best suited for investors who can benefit from LTCG indexation or have carry-forward losses to offset.
• Category III AIFs: Fund pays tax at maximum marginal rate (MMR) before distributing - this can simplify compliance but reduces flexibility.

2. Time Your Entry & Exit

• Entering just before a distribution cycle could increase your immediate tax liability.
• Exiting after meeting LTCG thresholds (e.g., >12 months for equity) can reduce your tax rate from 15% STCG to 10% LTCG.

3. Use DTAA if You’re an NRI

• Check if your country of residence has a Double Taxation Avoidance Agreement with India.
• Submit the required Tax Residency Certificate (TRC) to the fund to avail lower TDS rates where applicable.

4. Offset Gains Against Losses

• If you have capital losses from other investments, plan your AIF redemptions in the same financial year to set-off and reduce net taxable gains.

5. Factor in Surcharge & Cess

• High-income investors often underestimate the impact of surcharge (up to 37%) and cess (4%) on total tax payable.
• Always calculate post-surcharge tax before committing capital.

6. Keep Funds for Tax Payments Liquid

• Since distributions are irregular, set aside a portion in a liquid fund or NRE savings to cover advance tax instalments.

Want to Understand How AIF Taxation Affects Your Portfolio?

AIFs can be powerful tools for wealth creation, but their tax implications can make or break your net returns.

Our investment specialists at Finnovate can help you:

• Analyse the post-tax performance of shortlisted AIFs.
• Identify the right category and strategy for your risk profile.
• Integrate AIF allocations into your overall financial plan.

Book a Consultation Call and get clarity before committing large capital.