Alternative Investment Funds (AIFs) have become an important investment route for HNIs, family offices and institutional investors looking beyond traditional mutual funds and direct equity. But returns are only half the story. The other half is tax.
AIF taxation in India depends heavily on the category of the fund, the nature of income earned and whether the income is taxed at the fund level or passed through to investors.
The broad framework is simple:
- Category I and Category II AIFs generally get pass-through treatment for income other than business income.
- Category III AIFs generally face taxation at the fund level because they do not receive the statutory pass-through treatment available to Category I and II.
- Capital gains, interest, dividends and business income can have different tax consequences.
- TDS may be deducted even when the final tax liability is higher or lower than the amount deducted.
There is also an important 2026 update: the Income-tax Act, 2025 replaced the Income-tax Act, 1961 from April 1, 2026. The old Section 115UB framework for Category I and II AIFs has been carried into the new law primarily through Section 224. Similarly, the old Section 194LBB TDS provision is now reflected in the new Act's Section 393 framework.
What Is AIF Taxation in India?
AIF taxation refers to the tax treatment of income earned by an Alternative Investment Fund and its investors.
An AIF pools money from investors and invests it according to a defined strategy. Depending on the fund, the portfolio may include listed securities, unlisted companies, private credit, real estate-related investments, derivatives or other permitted assets.
The important question is not simply, "What is the AIF tax rate?"
The better question is:
Who is legally paying the tax, and what type of income is being taxed?
That distinction determines the AIF tax treatment.
For Category I and II AIFs, the tax law generally looks through the investment vehicle for eligible income. The investor is taxed as though the investment had been made directly, subject to the specific provisions of the law.
Under the new Income-tax Act, 2025, Section 224 states that income arising to a unit holder from investments made through an eligible investment fund is taxable in the same manner as if the investment had been made directly by that investor. The provision specifically covers Category I and Category II AIFs meeting the prescribed conditions.
Who Pays the Tax - the Fund or the Investor?
The easiest way to understand tax on Alternative Investment Funds is to separate the three categories.
| AIF Category | Broad tax approach | Who generally bears tax? |
| Category I | Pass-through for eligible non-business income | Investor |
| Category II | Pass-through for eligible non-business income | Investor |
| Category III | Fund-level taxation | Fund |
| Business income in Cat I/II | Taxed at fund level | Fund |
| Capital gains in Cat I/II | Pass-through | Investor |
For a broader explanation of strategy, leverage, liquidity and risk, see the differences between Category I, II and III AIFs.
This is a broad framework. The actual tax outcome can vary based on the fund structure, investor status, nature of income, underlying asset and applicable tax provisions. The distinction between business income vs capital gains in AIF is particularly important.
For example, if an eligible Category II AIF sells securities that qualify as capital assets, the resulting capital gains can generally pass through to investors. But business income does not receive the same pass-through treatment. That means two AIFs producing the same headline return can potentially produce very different post-tax returns from AIF investments.
How Is Category I AIF Taxed?
Category I AIF taxation generally follows the pass-through principle for eligible income.
Category I AIFs include funds focused on areas such as venture capital, infrastructure and other specified sectors under the SEBI framework.
For eligible income other than business income:
- The income is attributed to investors.
- Its nature is generally preserved.
- The investor pays tax according to the applicable provisions.
- The AIF itself generally does not become the final tax bearer for that pass-through income.
The new Section 224 of the Income-tax Act, 2025 maintains this approach. It also provides that income not actually distributed during the tax year can still be deemed to have been credited to the investor in the prescribed proportion.
A major clarification for securities
Budget 2025 made an important change for Category I and Category II AIFs by expanding the definition of a capital asset to include securities held by qualifying investment funds in accordance with applicable SEBI or IFSC regulations.
This matters because the change helps establish capital-gains treatment for the transfer of such securities rather than leaving their character open to a business-income interpretation merely because the fund is an investment vehicle.
The Income Tax Department's Budget 2025 FAQ specifically explained that securities held by eligible Category I and Category II AIFs would be treated as capital assets and that gains from their transfer would consequently be treated as capital gains and passed through to unit holders.
This is one of the most relevant Finance Act 2025 AIF changes (Budget 2025) for investors.
How Is Category II AIF Taxed?
Category II AIF taxation follows a similar pass-through framework.
Category II is particularly relevant for private equity, private credit, debt, real estate and other strategies that do not fall under Category I or Category III.
The basic principle is:
Fund earns eligible income → income retains its character → income passes through → investor pays tax.
For instance, suppose a Category II AIF earns capital gains from securities treated as capital assets. The gains can pass through to the investor as capital gains.
If the AIF earns interest, that income generally retains its character as interest income when passed through.
If the fund generates business income, however, that income is generally taxed at the fund level rather than simply being passed through to investors.
This is why investors should never assess AIF tax rates only by looking at the fund's category.
The underlying income mix matters.
How Is Category III AIF Taxed?
Category III AIF taxation works differently.
Category III AIFs typically use more active trading, hedging, derivatives or other complex strategies. Unlike Category I and II, Category III AIFs do not receive the statutory pass-through treatment under the investment-fund provisions.
The broad consequence is that income is generally taxed at the fund level.
Where the AIF is structured as a trust or another taxable entity, the applicable rate depends on the legal structure and relevant tax provisions. In cases where the Maximum Marginal Rate applies, the effective rate can be around 42.744%, including surcharge and health and education cess, depending on the circumstances.
This is why Category III AIF taxation requires more careful evaluation.
A fund may generate a strong pre-tax return, but the investor should focus on what remains after fund-level tax, management fees, performance fees and other costs.
For an HNI, the difference between a 15% or 20% investor-level capital-gains rate and a fund-level tax burden at the Maximum Marginal Rate can materially change the final outcome.
Category I vs Category II vs Category III AIF Taxation: Comparison
| Factor | Category I AIF | Category II AIF | Category III AIF |
| Pass-through status | Generally available | Generally available | Generally not available |
| Eligible capital gains | Investor-level taxation | Investor-level taxation | Generally taxed at fund level |
| Interest income | Generally passed through | Generally passed through | Generally fund-level |
| Business income | Fund-level taxation | Fund-level taxation | Fund-level taxation |
| Tax complexity for investor | Moderate | Moderate | Comparatively simpler |
| Key tax consideration | Nature of income | Nature of income | Fund-level tax burden |
| MMR relevance | Depends on fund/income | Depends on fund/income | Can be significant |
The key takeaway is straightforward: Category I and Category II AIF taxation is primarily investor-focused for eligible pass-through income, while Category III AIF taxation is primarily fund-focused.
What Is Pass-Through Taxation in an AIF? (Section 115UB)
AIF pass-through taxation means the tax is effectively imposed on the investor rather than taxing the same eligible income at both the fund and investor levels.
Under the old Income-tax Act, 1961, this framework was governed primarily by Section 115UB.
From April 1, 2026, the corresponding provision is Section 224 of the Income-tax Act, 2025.
The new provision preserves the core principle: eligible Category I and Category II AIF income is attributed to unit holders and taxed in their hands as if the underlying investment had been made directly by them.
There is an important catch: business losses and certain other losses are not simply passed through in the same way as eligible non-business income.
Section 224 specifically deals with losses and provides that business losses are dealt with at the investment-fund level rather than being passed through to investors in the ordinary manner.
How Are Capital Gains From AIF Investments Taxed?
Capital gains are one of the most important components of AIF tax treatment.
For Category I and Category II AIFs, qualifying securities are now expressly included within the capital-asset framework when held in accordance with applicable SEBI or IFSC regulations.
Therefore, gains from the transfer of those securities can be treated as capital gains and passed through to investors.
The applicable rate then depends on factors such as:
- Type of security
- Listed or unlisted status
- Holding period
- Whether the transaction qualifies for a special tax rate
- Investor's residential status
- Applicable surcharge and cess
For example, for eligible listed equity transactions, the post-2024 capital-gains framework generally provides for 20% STCG under Section 111A and 12.5% LTCG under Section 112A above the applicable exemption threshold.
The important point is that an AIF does not have one universal AIF tax rate. The tax rate follows the nature of income and applicable provisions.
How Are Interest and Dividend Income From an AIF Taxed?
Interest and dividend income generally retain their character when passed through by an eligible Category I or II AIF.
For the investor, this means:
- Interest income is generally taxed as interest income.
- Dividend income is generally taxed under the applicable dividend provisions.
- Capital gains are taxed under the capital-gains provisions.
- Business income follows the separate fund-level taxation mechanism.
This character-preservation principle is central to AIF taxation in India.
It also means investors should not assume that every rupee received from an AIF qualifies for capital-gains treatment.
Does TDS Apply to AIF Distributions? (Section 194LBB)
Yes.
Under the old framework, Section 194LBB required tax deduction on specified income paid or credited to unit holders of eligible investment funds.
For resident investors, the TDS rate was 10%.
From April 1, 2026, the corresponding provision is incorporated into Section 393 of the Income-tax Act, 2025, which retains a 10% TDS rate for specified investment-fund income payable to resident unit holders. For non-residents, tax is deducted at the rates in force, subject to the applicable rules and treaty provisions.
TDS is not necessarily the final tax.
If ₹10 lakh of taxable AIF income is subject to 10% TDS, ₹1 lakh may be deducted, but the investor's final tax liability could be higher or lower depending on the nature of income, tax rate, surcharge, cess, exemptions and other income.
Can AIF Losses Be Set Off by Investors?
This is an area where investors need to be particularly careful.
Pass-through taxation does not mean every AIF loss automatically becomes an investor's loss.
Under Section 224 of the Income-tax Act, 2025, business losses of the investment fund are dealt with at the fund level. Certain non-business losses may also be restricted from being passed through depending on conditions such as the holding period of the units.
Therefore, before assuming that an AIF loss can reduce your taxable income, check:
- The category of the AIF.
- The nature of the loss.
- The period for which the units were held.
- Whether the loss is eligible to be passed through.
- The applicable set-off and carry-forward rules.
The 15% Surcharge Cap: Why Income Type Matters for HNIs
For HNIs, surcharge can materially affect the final AIF tax treatment.
The enhanced surcharge applicable to certain high-income taxpayers is capped at 15% for specified categories of income, including income taxable under the capital-gains provisions such as Sections 111A, 112 and 112A under the old Act framework. The Income Tax Department's published tax guidance confirms this distinction. This creates an important difference between income types.
A high-income investor should therefore distinguish between:
- Capital gains
- Interest income
- Dividend income
- Business income
The headline tax rate alone does not tell the complete story.
Form 64C, Form 64D and ITR Reporting
Under the old framework, AIF investors were familiar with Form 64C, while the fund furnished Form 64D to the tax authorities.
The Income-tax Rules, 2026 continue to use these form numbers for investment funds under the new framework, with both forms linked to Section 224.
The broader reporting structure has, however, been updated under the new Act and Rules.
Investors should use the tax statement provided by the fund and reconcile:
- Income received or accrued
- Income category
- Capital gains
- TDS
- Losses, wherever applicable
- Taxable amount reported in the ITR
Do not simply enter the amount credited to your bank account. AIF taxation is based on the nature and tax treatment of income, not merely cash movement.
How Does AIF Taxation Work for NRI Investors?
For NRIs, AIF taxation adds another layer because residential status and tax treaties become relevant. Alongside taxation, non-resident investors should understand the rules for repatriating Indian investment returns through NRE, NRO and other permitted routes. Broadly, an NRI investing in an Indian AIF needs to examine:
- Whether the income is taxable in India
- Applicable TDS provisions
- The nature of the income
- Residential status
- Applicable Double Taxation Avoidance Agreement (DTAA)
- Tax Residency Certificate (TRC) requirements
- Foreign-country reporting requirements
For Category I and II AIFs, eligible pass-through income can be taxable directly in the hands of the NRI.
For non-residents, Section 393 provides for TDS at rates in force on specified investment-fund income. Treaty relief may be available where the applicable DTAA conditions are satisfied.
NRIs should therefore calculate the post-tax returns from AIF using both Indian tax and their home-country tax obligations.
AIF Taxation vs PMS Taxation: Key Differences
AIF vs PMS taxation is not a simple case of one being more tax-efficient.
| Factor | Category I/II AIF | Category III AIF | PMS |
| Basic tax structure | Pass-through for eligible income | Fund-level | Investor-level |
| Capital gains | Generally investor-level | Generally fund-level | Investor-level |
| Business income | Fund-level | Fund-level | Depends on treatment |
| TDS | Applicable on specified income | Depends on applicable structure/provision | Generally different mechanism |
| Tax complexity | Moderate | Fund handles much of the taxation | Investor-focused |
| Key consideration | Nature of income | Fund-level tax | Direct portfolio taxation |
For a broader comparison covering ownership, minimum investment, liquidity and fees, read our Mutual Fund vs PMS vs AIF guide.
Budget 2025 and the New Income-tax Act, 2025: What Changed
Two changes matter most for AIF investors.
1. Finance Act 2025
Budget 2025 clarified that securities held by qualifying Category I and Category II AIFs can qualify as capital assets when the investment is made according to applicable SEBI or IFSC regulations.
This supports capital-gains treatment and pass-through to investors.
2. Income-tax Act, 2025
The Income-tax Act, 2025 came into effect from April 1, 2026, replacing the Income-tax Act, 1961 for the new tax regime. The AIF pass-through provision now sits primarily in Section 224, while the TDS framework for investment-fund income is incorporated into Section 393.
So, when reading older AIF documents, investors may still see references to Section 115UB and Section 194LBB. For tax years governed by the new Act, the corresponding provisions need to be read under the new section numbering.
Important Tax Considerations Before Investing in an AIF
Before investing, calculate more than the advertised return.
Check:
- AIF category: Category I, II or III
- Fund structure: Trust, company, LLP or other structure
- Income mix: Capital gains, interest, dividends or business income
- Tax level: Fund or investor
- Applicable AIF tax rules: Including pass-through provisions
- TDS: Amount deducted and whether it is only an advance tax credit
- Surcharge and cess: Especially for HNIs
- Loss treatment: Whether losses can actually be passed through
- Fees: Management fee, performance fee and other expenses
- Investor status: Resident or NRI
- DTAA: Relevant for eligible non-resident investors
- Reporting: Form 64C/64D and ITR disclosures
A 20% pre-tax return is not necessarily better than a 17% return if the first strategy has a significantly higher effective tax and fee burden.
Conclusion
AIF taxation in India is category-driven, income-driven and investor-specific.
Category I and Category II AIFs generally benefit from AIF pass-through taxation for eligible non-business income, meaning investors are taxed on their share of income. Category III AIFs generally operate under a fund-level taxation model.
The 2025 capital-asset clarification was significant because it strengthened the capital-gains treatment of securities held by eligible Category I and II AIFs. Meanwhile, the Income-tax Act, 2025 has carried the core framework into a new section structure from April 2026.
For investors, the real question is therefore not simply, "What is the AIF tax rate?"
It is:
What income does the fund generate, where is that income taxed, what rate applies, how much TDS is deducted, and what remains after tax and fees?
That is the number that matters for your actual wealth creation.
Disclaimer
For Information Purposes Only: This content is provided solely for general informational and educational purposes and should not be considered as financial, investment, tax, legal, or professional advice. While every effort has been made to ensure the information is accurate and up to date, no guarantee or warranty is given regarding its completeness, accuracy, or applicability. Tax laws, regulations, rates, and interpretations may change over time. Readers should independently verify the information and consult a qualified financial or tax professional before making any investment or tax-related decisions. ALTPORT does not guarantee any investment outcome, return, or tax benefit based on the information provided.