A modern Investment Vehicle Alternative Investment Funds (AIF) and Its Taxation rules

Traditionally options to park our funds were limited to Real Estate, Bank FDs, Gold, Equity shares etc. However, there has been a pragmatic shift in the type of investments with options of high risk and high return namely Cryptocurrency, Mutual funds, PMS, AIFs etc.

One such option is Alternative Investment Funds (AIF). It is different from traditional investment options and its taxation rules makes it more complex than other investment options. In this article we have discussed the various taxation rules applicable in case of AIF.

What is AIF? :

AIF are the funds which collects the pool of money from the investors, whether Indian or foreign, for investment in accordance with a demarcated investment policy for the benefits of the investors. These funds further invest in hedge funds, private equity, venture capital, angel fund, REITs and many such alternative investment vehicle. These are specifically made for high-net-worth investors with customized investment needs as the minimum ticket size for investment in AIF is 1 crore. The Securities exchange board of India (SEBI) provides certain rules for operation and periodic compliance of AIF. As per SEBI rules, AIF can be established as a Company, trust, LLP, or Body corporate.

Parties involved in AIF :

Typically, the parties involved in an AIF structure includes Sponsor, manager, investor, and trustee in case legal form of AIF is trust. The role of each party is as follows:

  • Sponsor: Plays a vital role by way of investing the initial corpus in an AIF and sets up the AIF.
  • Manager: Responsible for making investment decision for funds pooled from investment.
  • Investors: Invest and holds beneficial interest in the AIF.
  • Trustee: Responsible for overseeing the process, ensuring compliance with regulatory framework.

Categories of AIF :

There are 3 different categories of AIF, namely:

  1. Category I (CAT I): AIFs of this Category, invest in economically and socially viable start-ups and Small and Medium Enterprises (SMEs) through social venture funds, infrastructure funds, venture capital funds, small and medium enterprise fund.
  2. Category II (CAT II): AIFs of this category, primarily invest in private equity funds and debt funds. These funds are closed ended. Leveraging is not permitted.
  3. Category III (CAT III): This category AIFs focuses on earning short term returns by deploying complex and diverse trading strategies. These AIFs can invest in commodity as well. Further, leveraging is permitted either through investment in derivatives or borrowing subject to prescribed conditions.

Tax implication on AIF (category wise) :

Now, before discussing the taxation rules of AIF, it is imperative for you to know the factors which impact taxability of AIF, there are basically 2 factors:

  1. Firstly, although all the 3 categories of AIF are taxed but the taxability will depend on and vary with each category.
  2. Secondly, the legal form (whether Company, LLP, or trust) of AIF will dictate the tax rules.

Tax implications for each category is discussed here below:

  • (CAT I & CAT II ) :

CAT I & CAT II has been granted pass through status which means that any income or loss (other than business income) generated by CAT I and CAT II fund shall be taxed in the hands of the investor in the same manner as if the income were accruing or arising to or received by such person, if the investments made by AIF had been directly made by him. Such income is exempt in the hands of the fund u/s 10 (23FBA). As per section 115UB read with section 10(23FBA) and 10(23FBB), Business income is taxable at maximum marginal rate in the hands of AIF and is exempt in the hands of Investor. AIF to withhold tax on income (other than business income) paid/credited to resident investor at the rate of 10%.

So, in simple terms, if you invest in any of these two categories of the AIF, then you need to pay capital gain tax on the profit or loss you make from the fund within a given duration. The duration is very important as to decide whether it is long term capital gain (held for more than 24 months) or short-term capital gain (held for or less than 24 months).

LTCG is taxable at the rate of 20% with indexation benefit and STCG at 15%. There are surcharge and cess on and above-mentioned rates.


Unlike Category I & Category II, there is no specific tax regime for Category III AIFs. This category of AIF has no pass-through status. Therefore, the income earned by these AIFs is taxable depending upon the legal structure of the fund (i.e., company, trust, LLP)

A category III AIF pays tax on the following 4 types of incomes:

  • Short-term capital gain
  • Long-term capital gain
  • Business Income
  • Dividend Income
    Tax type Short-Term Capital Gains Long-Term Capital Gains Business Income Dividend Income
    Basic tax 15% 10% 30% 30%
    Surcharge over tax 15% 15% 37% 37%
    Education Cess 4% 4% 4% 4%
    MMR 17.94% 11.96 42.74 42.74

    The highest rate of tax is charged on profit generated by this fund.


    AIF is a fairly sophisticated investment vehicle and the taxation rules make them even more complicated for general investors. But the crux is, if someone is investing in category III AIF, the onus of tax is on  the fund and not on the investor, however, in case of other 2 categories i.e. CAT I and CAT II, since taxation is on the investor, it would be important to understand the tax implication before making an investment.

Author : Kapil Nayyar

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