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The Alternative Investment Funds (AIFs) in India have become a preferred investment route for HNIs, NRIs, and family offices. They seek direct exposure to alternative assets such as startups, private equity, real estate, or hedge funds. However, to make an investment decision, just seeing good returns is not enough. In reality, how much money an investor has depends on the after-tax returns. Despite attractive IRRs, the net return is reduced due to taxes.
The Union Budget 2025 and the recent changes related to capital gains have added a new dimension to AIF taxation in Category I and II AIFs under the pass-through regime. Therefore, it is more important to clearly understand the tax rules before investing in AIFs. These updates directly impact capital gains, compliance obligations, and TDS for a clear understanding of AIF tax rules that are non-negotiable.
Read this blog to know AIF, its classification, understand AIF tax rules in India 2026, the impact of the Union Budget 2025 on your after-tax returns, and tips for AIF investors. AIF registration seekers must know about the AIF tax rules in India 2026.
An Alternative Investment Fund (AIF) is an investment structure where the money of multiple investors is pooled and invested in various assets outside the conventional market. These funds usually invest in startups, private companies, infrastructure projects, real estate, or derivatives.
Compared to mutual funds, AIFs have a more flexible investment strategy and are also relatively riskier. AIFs are a pooled structure where everyone is a shareholder in the same fund.
In India, AIFs are regulated by SEBI allowing only investors who meet certain qualifications to invest in AIFs. Generally, high-net-worth individuals, corporates, NRIs, and family offices are the main investors in AIFs.
SEBI has divided AIFs into three different categories based on the type of investment and risk. AIF Tax rules 2026 are determined depending on these categories.
Category I AIFs mainly invest in sectors that are conducive to the economic or social development of the country. These include startups, venture capital, infrastructure, and social venture funds.
The major advantage of this category is pass-through taxation. The fund itself does not pay taxes, but the income is directly taxable in the hands of the investor. In some cases, tax exemptions may also be available on income from infrastructure or social sectors. One must understand AIF Category I compliance requirements properly.
Category II AIFs generally invest in private equity, debt funds, real estate or unlisted companies. This category is most popular among HNIs.
Pass-through taxation applies. However, if the income of the fund is treated as “business income”, then that part has to be taxed at the fund level. The remaining capital gains or interest income are taxable to the investor. Category II AIF compliances are to be taken care of.
Category III AIFs generally operate like hedge funds. They generate returns through short-term trading, derivatives, or leverage.
There is no pass-through facility in this category. Fund income is directly taxable at the highest marginal rate at the fund level. The money distributed after taxes goes to the investor.
When investing in AIFs, many people only look at the gross return or IRR. But the most important thing for investors is the net return.
Even well-performing funds can yield lower returns than expected due to the wrong tax structure. So, tax plays a big role in choosing AIF categories and entry or exit decisions.
Also, the tax rules are not the same for residents and NRI investors. TDS, DTAA benefits, and repatriation can change the tax outcome.
Understanding AIF taxation makes the entire investment strategy more effective and planned.
Look at the table given below to know AIF tax comparison 2026 by category.
The income of Category I AIFs is generally taxable at the investor level. The fund itself does not pay tax. Tax exemptions under Section 10 may be available for certain income from the startup or infrastructure sectors. This category is tax advantageous for investors with a long-term perspective.
The pass-through principle also applies to Category II AIFs. Only business income is taxable at the fund level. This category includes private equity and debt funds, offering greater opportunities for capital gains. Therefore, it is the most popular among HNIs (High Net Worth Individuals).
Income from Category III AIFs is taxable at the fund level. The effective tax rate can go up to approximately 42.7%. This category remains relevant for those seeking short-term trading or hedging strategies.
Look at the table given below to know taxation on income types in AIFs:
The tax rate on capital gains earned through AIFs depends on the type of investment and the holding period. LTCG is generally taxable at 12.5% or 10%, depending on the circumstances, for listed assets. STCG is generally taxable at 20% or the individual’s slab rate.
Some changes have been introduced in the rules after July 23, 2024. Specifically, transitional relief has been provided for real estate-related investments to avoid additional tax burdens on old investments.
Here is a given table that outlines how AIF taxation differs at the investor level for resident and non-resident investors, highlighting various subjects under Indian tax laws.
For resident investors, capital gains, interest income, and dividends received from AIF are considered as their own income. These are taxable as per the personal tax structure. In case of high income; surcharge and cess tax may be added, increasing the total tax burden.
In many cases, advance tax is required. Especially if there is a large amount of AIF income, there is a risk of interest and penalty if advance tax is not paid on time.
Taxation is slightly different for NRIs and foreign investors. They can avail the benefits of DTAA (Double Taxation Avoidance Agreement), which can result in lower effective tax rates. However, it is essential to have a Tax Residency Certificate (TRC), Form 10F, and PAN.
As per FEMA rules, certain procedures have to be followed before remitting the income received from AIF abroad. Without proper documents, repatriation may be delayed.
These are the key TDS obligations for AIFs and investors that require close attention to avoid leakage, penalties, and downstream compliance risks.
In the case of Category I AIFs, tax exemptions are available on certain income under Section 10 of the Income Tax Act. Funds investing in startups, infrastructure projects, and social enterprises can avail themselves of this facility.
The government provides certain exemptions for income related to infrastructure and social ventures so that long-term investments are encouraged. In addition, some operational expenses at the fund level can be claimed as deductions.
In case of losses, loss of set-off and carryforward are possible if certain conditions are met. However, the correct classification of income and loss is very important. This benefit is not available in case of incorrect reporting.
This section outlines the statutory tax filing and ongoing AIF compliance requirements applicable to AIFs under tax regulations.
AIFs are generally required to file ITR-5. ITR-7 may be applicable in some special cases.
Alternative investment fund audit is mandatory if certain turnover or income limits are crossed. It is very important for the fund to file returns and audit reports within the prescribed time frame. Delays can lead to penalties and interest.
General investors use ITR-2, while those with business income may have to file ITR-3. Using AIFs annual statement and Form 64C for documentation. Provide your gross income in ITR and claim credit for TDS deductions by the AIF. The most common mistake is showing income in the wrong head or TDS mismatch. To avoid these, it is important to reconcile the forms and statements well. Payment of advance tax, if it exceeds ₹10,000 annually.
The Union Budget 2025 has brought clarifications regarding AIF taxation for income under Category I and II as capital gains. It will be effective from FY2025-26 / AY 2026-27.
The biggest change has come in the capital gains structure. An attempt has been made to rationalize tax rates across different asset classes, allowing investors to understand the tax outcomes in advance.
The budget has also provided clear guidance on the taxation of carried interest. Previously, there was confusion regarding whether it would be treated as capital gains or business income. This new clarification will allow fund managers to plan their taxes with greater certainty.
The budget has also had a positive impact on NRI and foreign investors. Uncertainty regarding DTAA application, TDS, and reporting has decreased. So, the AIF structure is now more transparent and predictable for international investors. This will help in making long-term investment decisions.
Tax planning is crucial before investing in Alternative Investment Funds. Making the right decisions can help you retain more money from the same returns.
Investing in AIFs is not just about choosing a good fund. The real key is aligning your investment strategy with the correct tax rules. Category selection, type of income, and exit timing, everything together determines the final net return. The 2025 regulations and recent changes have made AIF taxation more structured, but it remains complex. Incorrect planning can lead to unnecessary tax burdens.
Enterslice assists investors, fund managers, and NRIs in AIF structuring, compliance, and optimizing post-tax returns. Speak to our experts today for solutions tailored to your AIF tax and compliance needs.
Category I and Category II AIFs generally do not pay tax themselves. The income earned by the fund is directly attributed to the investor. The investor pays tax on it as part of their own income. If the income is a capital gain, it is taxable as a capital gain. However, if any income is considered business income, then tax is levied at the fund level.
The tax rules for Category III AIFs are different from the other two categories. There is no pass-through benefit here. The fund itself pays taxes. Generally, tax is deducted at the maximum tax rate, which can be close to 42%, including surcharge and cess tax. After paying tax, the fund distributes the money to the investors. Usually, this money is not taxable again in the hands of the investor.
The tax on capital gains from AIFs depends on how long you have held the investment. The tax rate is lower, usually 10% or 12.5% for long-term holdings. The tax rate is higher, often 20%, or according to the tax slab for short-term sales. Due to recent rule changes, determining the investment holding period is now even more important.
Yes, losses from AIF investments can be set off. Capital losses can generally be offset against capital gains. If the entire loss is not offset in the same year, it can be carried forward to future years according to specific rules. However, the rules for all types of losses are not the same, so accurate reporting is crucial.
The Union Budget 2025 has brought some clarity regarding carried interest. Now, it may be treated as capital gain, not as business income. This has simplified tax planning for fund managers. However, this depends entirely on the fund structure, the terms of the agreement, and the duration of the investment.
NRI investors can often pay less tax if they avail DTAA benefits. They don't have to pay tax on the same income in two countries. The investor needs to provide a Tax Residency Certificate, Form 10F, and an Indian PAN to avail this benefit. DTAA benefits cannot be availed, and higher TDS will be deducted without the correct documents.
Forms 64C and 64D are summaries of income received from AIFs. They contain information about the investor's income, the type of income, and the TDS deducted. These forms are very useful when filing income tax returns. If the information in these forms does not match Form 26AS, it can lead to problems with the return or the risk of receiving a notice.
AIF investors have to pay advance tax in many cases. Advance tax is applicable if the annual taxable income exceeds a certain limit. Since AIF income can come in lump sums, many people miss this. Failure to pay advance tax results in interest charges later, so it's best to calculate your taxes in advance.
The most common mistake is misrepresenting the type of income. Many people do not differentiate between capital gains and interest income. Other major mistakes include not reconciling TDS, choosing the wrong ITR form, and not paying advance tax. These can lead to unnecessary taxes, interest, or income tax notices.
If the income from the AIF is from capital gains or other sources, ITR-2 is generally used. However, if the AIF income needs to be shown as business income, then ITR-3 must be filed. Using the correct ITR form is crucial, as using the wrong form can lead to the return being rejected.
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