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 surcharge, cess, and withholding (TDS) 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 (Category I & II)

• Under Section 115UB, all income other than business income (e.g., interest, dividends, capital gains) is exempt at the fund level and taxable in the hands of investors in proportion to their share, retaining the same nature.
• If the AIF earns business income, that portion is taxed at the fund level (rate depends on fund structure; trusts are generally taxed at the maximum marginal rate).

b) Taxed at Fund Level (primarily Category III)

• Income is generally computed as business income and taxed at the AIF level. Post-tax amounts are then distributed to investors.
• Investors typically report the distributed amounts in their ITRs but avoid double taxation in India on the same stream.

c) Reporting & Compliance

Regardless of the structure:

• AIFs must file statements with investors and the Income Tax Department (Form 64C to investors; Form 64D to the department).
• Investors include their share of pass-through income in their ITRs.
• TDS (Section 194LBB) applies differently for residents and non-residents (see details below).

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, interest, dividends and capital gains pass through to investors and retain their character; only business income (if any) is taxed at fund level.
• For Category III, investors have no control over their own slab; returns are post-fund tax.
• NRIs should assess TDS under Section 194LBB and evaluate DTAA benefits (TRC/10F required).

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

• For transfers on/after 23-Jul-2024:
  • Long-Term Capital Gains (any capital asset): 12.5%, no indexation; equity-like assets (listed equity, equity MF, units of business trust covered by s.112A) enjoy an exemption of ₹1.25 lakh per FY.
  • Short-Term Capital Gains u/s 111A (STT-paid listed equity/equity MF/units of business trust): 20%.
  • Other STCG (non-111A): taxed at your slab rate.
• For transfers up to 22-Jul-2024 (older rule):
  • Equity LTCG (s.112A): 10% on gains above ₹1 lakh.
  • STCG u/s 111A: 15%.

Transitional relief (immovable property): For resident individuals/HUFs selling land or building acquired before 23-Jul-2024, if tax computed under the new rule (12.5% without indexation) exceeds the tax under the old rule (20% with indexation), the excess is ignored - effectively allowing you to pay the lower amount.

For Category I & II AIFs, capital gains are passed through to investors (retaining their nature) and must be reported in the investor’s own tax return.

b) Interest Income

• Category I & II: Pass-through - interest is taxed in the investor’s hands at the applicable slab rate.
• Category III: Typically treated as business income and taxed at the fund level. Investors receive post-tax distributions.

Note: All rates are exclusive of applicable surcharge and 4% health & education cess. NRIs may be eligible for lower rates or relief under DTAA with a valid TRC (and Form 10F where required).

c) Business Income

• Primarily relevant for Category III AIFs that trade frequently or use derivatives.
• Income is computed as business income and taxed at the fund level; effective rate in trust structures can be up to ~42.744% (incl. surcharge & cess).
• 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 can still be attractive due to pass-through and character retention of capital gains/interest/dividends.
• Category III suits investors prioritising absolute returns over individual tax optimisation.
• NRIs should evaluate withholding and DTAA relief proactively.

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, pass-through income (interest, dividends, capital gains) must be declared in the relevant schedules of your Income Tax Return (ITR).
   • Even if the fund deducts TDS, report the gross amount and claim credit.
   • FY 2024–25 filing tip: Due to mid-year capital-gains changes (effective 23-Jul-2024), report pre- and post-date gains separately in your ITR schedules.
2. Maintain Documentation
   • Annual Statement of Account from the AIF.
   • Form 64C: Statement of income distributed by the fund.
   • Contract notes / proof of investment for audit trail.
3. Advance Tax
   • If your net tax liability exceeds ₹10,000 in a year, pay advance tax in four instalments to avoid interest.

b) For NRI Investors

1. TDS on Distributions (Sec. 194LBB)
   • Residents: AIF deducts TDS at 10% on income distributed.
   • Non-residents: TDS at rates in force for the underlying income type. DTAA may reduce the rate with a valid Tax Residency Certificate (TRC) and, where needed, Form 10F.
   • PAN & DTAA docs: Non-residents should provide PAN, TRC and, where required, Form 10F. If PAN isn’t furnished, Section 206AA may trigger higher TDS.
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; generally due by 15 June of the following financial year.
3. Filing ITR in India
   • Even with TDS deducted, you may need to file an ITR in India if you have taxable income here.
   • Use ITR-2 for capital gains/other income; ITR-3 if you have business income attributable.
4. Repatriation Compliance
   • For remittance of gains, comply with RBI’s FEMA procedures and bank documentation (e.g., Form 15CA/15CB as applicable).

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 means taxes are levied in your hands (slab for interest/dividends; capital gains as per current rules). Useful if you can use loss set-offs or exemptions.
• Category III AIFs: Fund pays tax at maximum marginal rate before distributing - simpler for compliance but less flexible.

2. Time Your Entry & Exit

• Entering just before a distribution cycle could increase immediate tax liability without commensurate gains.
• Plan exits mindful of holding periods and the 23-Jul-2024 rule change for capital gains.

3. Use DTAA if You’re an NRI

• Check if your country of residence has a DTAA with India.
• Submit a valid TRC (and Form 10F where required) to the fund to avail lower TDS rates.

4. Offset Gains Against Losses

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

5. Factor in Surcharge & Cess

• High-income investors should model the impact of surcharge (up to 37%) plus 4% cess; Category III fund-level rates can approach ~42.744%.

6. Keep Funds for Tax Payments Liquid

• Since distributions may be irregular, park a portion in liquid instruments to meet advance tax instalments comfortably.

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.