Chapter 16: Taxation

The taxation of Category I and Category II AIFs is governed by Section 115UB of Chapter XII-FB of the Income-tax Act, 1961.

Pass-Through Status Mechanics

• Complete Pass-Through: Income earned by a Category I or II AIF (other than business income) is exempt from tax at the fund level and is taxed directly in the hands of the unit-holders.
• Character Preservation: The original character of the income (LTCG, STCG, dividend, interest) is preserved in the hands of the investor.
• Business Income Exception: Any income characterized as Business Income is taxed at the fund level at the Maximum Marginal Rate (MMR) (currently ~42.74%). Once taxed at the fund level, it is exempt in the hands of unit-holders under Section 10(23FBA).
• TDS Under Section 194LBB: The AIF must deduct tax at source (TDS) at 10% for resident investors, and at applicable domestic/DTAA rates for non-resident investors upon credit or distribution.

Unlike Category I and II AIFs, Category III AIFs are excluded from Section 115UB pass-through status.

Trust Taxation at the Fund Level

• Over 95% of Category III AIFs operate as contributory private trusts under the Indian Trusts Act, 1882.
• Because open-ended funds have fluctuating investor counts and variable profit-sharing ratios, they are classified as Indeterminate Trusts under Section 164 of the Income-tax Act.
• Consequently, a Category III AIF is taxed at the Fund Level as an Association of Persons (AOP) at the Maximum Marginal Rate (MMR) (~42.74%).
• Section 43(5) Business Income: Gains from trading exchange-traded futures and options are classified as non-speculative business income, taxed at MMR after deducting fund operational expenses.
• Tax-Free Distributions: Once the fund discharges its entity-level tax liability, subsequent distributions of net profits or redemption proceeds to unit-holders are completely tax-free in the hands of investors under Section 10(23D).

AIF managers must navigate complex anti-avoidance provisions and international tax treaties.

1. General Anti-Avoidance Rules (GAAR) and MLI

• GAAR: Empowers tax authorities to declare any arrangement an Impermissible Avoidance Arrangement (IAA) if its main purpose is to obtain a tax benefit and it lacks commercial substance. Cross-border fund structures must maintain real economic substance (local offices, resident directors, active decision-making).
• Multilateral Instrument (MLI): Enforces the Principal Purpose Test (PPT) across Double Taxation Avoidance Agreements (DTAAs), eliminating treaty-shopping structures that lack bona fide commercial purpose.

2. GIFT City IFSC Tax Exemptions (Section 10(4D))

Category III AIFs established in the International Financial Services Centre (IFSC) in GIFT City, Gujarat, enjoy significant statutory incentives:

• 100% Tax Exemption on Capital Gains: All income from the transfer of offshore securities, foreign currency bonds, and overseas derivatives is completely exempt from income tax.
• No Domestic Surcharge Drag: Non-resident investors in a GIFT City Category III AIF are exempt from the 37% domestic surcharge.
• 0% GST on Management Fees: Services rendered by an IFSC manager to an offshore fund or foreign investors are treated as zero-rated exports under Section 16 of the IGST Act.