Is AIF Tax Free? The Myth, the Pass-Through Rule and the Reality

If you have searched "is AIF tax free", you probably heard the phrase from a distributor or a fund deck. The honest answer is no. Every rupee an Alternative Investment Fund earns is taxed somewhere. What changes from one fund to the next is who pays, when, and at what rate.

Three cases cover almost every AIF sold in India:

• Category I and II AIFs have a statutory pass-through. The fund does not pay tax on its investment income. You do, as if you had made the investments yourself.
• Category III AIFs have no pass-through. The trustee of the fund pays tax before money reaches you.
• Certain GIFT City funds get specific exemptions, written for non-resident investors.

This matters to a lot of money. SEBI's quarterly data shows AIF commitments of ₹17,53,070 crore as of 30 June 2026, with Category II at ₹13,02,837 crore (about 74%) and Category III at ₹3,37,192 crore (about 19%). SEBI sets the minimum ticket at ₹1 crore for most investors, so a wrong assumption about tax is an expensive one.

This article covers AIF taxation only, not how units, NAV or lock-ins work. Rules are stated as on 5 October 2026. Confirm your own position with a chartered accountant.

The "AIF tax free" line grows out of three statements that are each partly true.

"The fund pays no tax." True for most income of a Category I or II fund. But the tax has not disappeared. It has moved to you.

"You pay no tax on what you receive." This is said about Category III funds, and several fund-house and trade pages put it almost in those words. The reason given is that the fund has already paid. So the return is post-tax, not untaxed.

"GIFT City funds are exempt." Some are, for some income, for some investors. The conditions are strict.

Put the three together in a sales conversation and you get "AIFs are tax free". Separate them and the claim falls apart. The useful reply is another question: which category, what kind of income, and are you resident in India?

The myth also survives because the tax is hard to see. In a pass-through fund it arrives months later in a statement of income. In a Category III fund it is buried inside the NAV.

The AIF tax rules were added in layers, and each layer explains a piece of today's confusion.

• Before 2015: pass-through treatment existed only for venture capital funds and companies.
• 2012: SEBI's AIF Regulations created the three categories used today.
• 28 July 2014: CBDT Circular 13/2014 said an AIF set up as a trust would be treated as indeterminate, and taxed at the maximum marginal rate, unless investors' names and shares appeared in the trust deed.
• Finance Act, 2015: Section 115UB was inserted into the Income-tax Act, 1961. It gave Category I and II AIFs pass-through status for income other than business income.
• 1 April 2019: loss pass-through began. Non-business losses sitting in funds on 31 March 2019 were deemed to be losses of the unit holders.
• 23 July 2024: capital gains rates and holding periods were rewritten.
• Finance Act, 2025: securities held by Category I and II AIFs were declared capital assets.
• 29 July 2025: the Delhi High Court read down the 2014 circular for Category III AIFs.
• 1 April 2026: the Income-tax Act, 2025 replaced the 1961 Act.

That last step changes every section number in this subject. The government's release says the new Act came into force on 1 April 2026 and was written "without altering the underlying tax policy". The Income Tax Department adds that it has 536 sections and 16 schedules against 819 sections earlier, and uses a single "tax year" in place of previous year and assessment year.

Most articles on AIF taxation still quote only the 1961 numbers. This mapping is taken from the Gazette text of the 2025 Act and cross-checked against the section-mapping table published by the Institute of Chartered Accountants of India (ICAI).

Income earned up to 31 March 2026 is still assessed under the 1961 Act, so you will see both sets of numbers for a while. This article says "Section 115UB" where most investors know the rule by that name.

Pass-through status has three moving parts. The wording below is from section 224 of the Income-tax Act, 2025 (Act No. 30 of 2025, published in the Gazette of India and linked from the PIB release above), which restates Section 115UB.

The core rule says income you receive from an investment fund is taxed "in the same manner as if" the investments made by the fund had "been made directly by him", meaning by you. A second sub-section adds that the income is deemed to be "of the same nature and in the same proportion" in your hands as it was in the fund's.

So a long-term capital gain in the fund is a long-term capital gain for you, and interest stays interest. The fund itself is exempt on this income so that it is taxed once, not twice.

Only Category I and Category II funds have pass-through status. The Act defines "investment fund" as a fund holding one of those two registrations under SEBI's AIF Regulations or under the IFSCA Fund Management Regulations. Category III is not in the definition.

Pass-through status does not cover everything. If the fund earns income under the head "profits and gains of business or profession", the fund pays tax on it. The rate is the normal company or firm rate if the fund is a company or an LLP, and the maximum marginal rate "in any other case", which includes the trust structure most AIFs use. Your share of that business income is then exempt in your hands.

If the fund earns income in a tax year and does not pay it out, the Act deems it to have been credited to you on the last day of the tax year, in the proportion you would have received. You owe tax on it that year. When the cash finally arrives, it is not taxed again.

Section 115UB can hand you a tax bill before it hands you money.

Under Section 115UB income keeps its character, so your tax depends on what the fund earned. The rates below apply to resident individuals for transfers on or after 23 July 2024, as set out in the government's memorandum to the Finance (No. 2) Bill, 2024 and carried into the 2025 Act.

Surcharge and a 4% cess sit on top. For individuals, surcharge on dividends and on the capital gains taxed at special rates is capped at 15%. On other income it can reach 25% under the new tax regime and 37% under the old regime for income above ₹5 crore.

Assume your share of a Category II fund's income for tax year 2026-27 is a ₹20 lakh long-term gain on unlisted shares and ₹10 lakh of interest. You are in the new regime, in the 30% slab, with total income between ₹2 crore and ₹5 crore.

• Long-term gain: ₹20,00,000 × 12.5% = ₹2,50,000. Add 15% surcharge and 4% cess: ₹2,99,000, an effective 14.95%.
• Interest: ₹10,00,000 × 30% = ₹3,00,000. Add 25% surcharge and 4% cess: ₹3,90,000, an effective 39%.
• Total tax: ₹6,89,000 on ₹30 lakh of income, about 23%.

The fund will have deducted ₹3,00,000 as TDS. You pay the remaining ₹3,89,000 yourself.

Give the same ₹30 lakh to a co-investor whose other income is modest. With no surcharge, the gain costs 13% and the interest is taxed at a lower slab. Pass-through status makes the tax personal, which is why a fund cannot quote one "post-tax return" for all its investors.

TDS on AIF distributions to resident unit holders is 10%, with no threshold, on income other than the business-income share that is exempt for you. Under the 1961 Act this was Section 194LBB; it now sits in the table to section 393(1). For non-resident unit holders the Act says "rates in force", which brings in the rate for that type of income and any tax treaty relief.

Three things follow:

• The 10% is credited against your final liability, which can be more than twice that.
• TDS on AIF distributions can apply when income is credited to your account, even if you have not been paid.
• Advance tax is your job. If a large credit lands in March, interest for short payment of advance tax can follow.

The fund must also give you, and the tax department, a statement showing the nature of the income. Under the 1961 rules these were Form 64C and Form 64D. Forms have been renumbered under the Income-tax Rules, 2026, so use whatever form name your fund's statement carries for tax year 2026-27.

Loss pass-through is narrower than income pass-through:

• Business losses stay with the fund. It carries them forward and sets them off itself.
• Other losses, such as capital losses, can pass to you only if you have held the unit for at least twelve months. If you have not, the loss is simply ignored for your tax computation.
• Once a loss is yours, the ordinary set-off and carry-forward rules apply to it.

So an investor who entered a fund eight months before it booked a capital loss cannot use that loss.

Category III funds run listed-equity, long-short and derivatives strategies. They are outside Section 115UB, so Category III AIF taxation falls back on the general law for the fund's legal form. Most are trusts.

A trustee is taxed as a "representative assessee", and the Act says tax is levied on the trustee "in like manner and to the same extent" as it would be on the beneficiaries. Two exceptions push the rate up:

• If the beneficiaries' shares are indeterminate or unknown, the income is taxed at the maximum marginal rate.
• If the trust earns business profits, those are taxed at the maximum marginal rate.

The maximum marginal rate is the highest slab rate plus surcharge. With a 37% surcharge it works out to 42.744%; under the new-regime ceiling of 25% it is 39%. Derivatives trading is generally treated as business income, so a fund that trades futures and options heavily sits at the top of that range. A long-only listed-equity fund treated as determinate can be closer to 14.95% on long-term gains and 23.92% on short-term gains at the 15% surcharge cap.

That is why one percentage cannot describe Category III AIF taxation.

For a decade the 2014 circular made "indeterminate" the default reading. In Equity Intelligence AIF Trust v. CBDT, decided on 29 July 2025, the Delhi High Court read the circular down. KPMG's summary records the holding that Category III AIFs "cannot be deemed indeterminate trusts solely due to the absence of investors' identity" in the trust deed, because SEBI's rules do not allow a fund to take investors before it is registered.

It is a High Court decision on one fund's facts. As of 5 October 2026 we found no report of an appeal, and no legislative change has followed. Separately, a Mumbai tribunal Special Bench held in April 2025 that, at the maximum marginal rate, surcharge applies "in a graded manner" by income level. That case concerned a private discretionary trust, not an AIF.

And what about you, the investor? The common position is that distributions from a Category III fund are not taxed again in your hands, because the Act lets the department assess either the trustee or the beneficiary on the same income, not both. No clause says "exempt" in so many words, so rely on the fund's tax note and your adviser, not on a one-line promise.

The exemptions formerly in Section 10(4D), now in Schedule VI of the 2025 Act, are given to a "specified fund". The Act defines that as a fund located in an International Financial Services Centre, registered as a Category III AIF (or as an IFSCA retail scheme or exchange-traded fund), "of which all the units are held by non-residents". The only exceptions are units held by the sponsor or manager and a small carve-out, capped at 5% of units, for investors who later become resident.

For such a fund, the Act exempts specific income: gains on certain assets traded on an IFSC exchange, gains on securities other than shares of Indian resident companies, income from securities issued by non-residents, and business income from a securitisation trust.

Three points keep this in proportion:

• These exemptions are built for non-resident money. A fund that takes resident Indian investors does not meet the "all the units are held by non-residents" test.
• A Category I or II fund in GIFT City is an "investment fund" under the same pass-through rule as a mainland one. It gets pass-through status, not exemption.
• Gains on shares of companies resident in India are carved out of the general securities exemption.

So in GIFT City the answer is: sometimes, for a non-resident, in a qualifying fund, on the listed kinds of income. If you want the clause-by-clause detail, PMS Sahi Hai has separate guides on Section 10(4D) for GIFT City funds and Section 10(4E).

Three Budgets in a row changed the AIF tax rules in this article. A note that predates any of them is stale.

On the 2025 change, the government's memorandum said there was "uncertainty in characterization" of fund income, and the amendment makes any security held by a Section 115UB fund a capital asset. For a Category II private equity investor this means share-sale profits come to you as capital gains instead of being trapped in the fund as business income at the maximum marginal rate.

The 2026 round left the core of AIF taxation alone. The Finance Bill, 2026 memorandum states that income-tax rates were not changed, raises securities transaction tax on derivatives, moves buy-backs to capital gains, and tidies the IFSC "specified fund" definition. The Bill received the President's assent on 30 March 2026. Higher STT is a trading cost for derivative-heavy Category III funds, not a change in how their income is taxed.

None of this makes AIFs tax-inefficient. Pass-through status is a real benefit, just not the one the myth describes.

• One level of tax. Investment income is exempt in the fund and taxed once, in your hands.
• Character is preserved. A long-term gain stays long-term, so the 12.5% rate and the 15% surcharge cap follow it to you.
• Your own rate applies. A lower-slab investor, or an entity with its own tax profile, is not dragged up to the top individual rate.
• Losses can come through. Non-business losses reach you after twelve months of holding and can be set off against your other gains.
• More certainty since 2025. Share sales by Category I and II funds are capital gains by definition.
• TDS is creditable. The 10% deduction reduces what you pay later.
• Reporting is mandatory. The fund must tell you the nature of every rupee it credits to you.

AIF taxation paperwork is also manageable. Because the fund reports the same figures to the department, your statement of income should match your Annual Information Statement and TDS credits. With the 2025 Act's single "tax year", fund statements, TDS certificates and your return carry the same year label.

A headline return tells you nothing about where the tax sits. Two AIFs with the same number can leave you with very different amounts once the category, the type of income and your own slab are applied. That is the gap PMS Sahi Hai is built to close.

Start with the category, not the brand. PMS Sahi Hai's explainer on what an AIF is makes the same point this article does: with an AIF "you pick a category" first. Its page on AIF categories sets Category I, II and III side by side, including the line that Category I and II are pass-through while Category III is taxed at the fund level. Read that before you read any fund deck.

Compare on one basis. The AIF comparison page lets you filter tracked funds and shortlist up to four to compare side by side. Each carries a Nyra Score on a 0–10 scale. Nyra is PMS Sahi Hai's AI research tool, and its published methodology scores strategies on five pillars: return performance, risk-adjusted return, downside protection, consistency, and structure and stewardship.

Know what the score does not do. The methodology page lists its own limits: the score is "not a prediction" and "not a recommendation", and it adds that a 9.2 strategy "can be completely wrong for your risk profile, horizon or tax position". That is the right way to use it alongside this article: let the score narrow the field, then run the seven tax checks below on each shortlisted fund.

Ask Nyra, then ask a person. The Nyra page promises "every answer source-cited" and is equally plain that "Nyra is an analytical tool, not a SEBI-registered Investment Adviser". Use it to pull up a fund's category and structure quickly. For NRIs, the GIFT City hub notes that "eligibility and treatment depend on the specific fund and your country of residence". When you want a person to walk through a shortlist, PMS Sahi Hai, which is APMI-registered, offers a 15-minute private consultation through its contact page.

None of these replaces a chartered accountant. They make sure that when you sit down with one, you already know which category you are discussing and which questions are still open.

Here is where AIF taxation is unsettled or simply unfavourable.

• Tax before cash. The deemed-credit rule can create a liability in a year with no distribution.
• Business income is still caught. The 2025 fix covers securities. A fund earning other income that is treated as business income still pays at the maximum marginal rate, and business losses stay locked in the fund.
• Interest gets no relief. Pass-through status does nothing for a private credit fund's interest income, which is taxed at your slab rate. The industry told the government before Budget 2026 that debt-oriented AIF income faces a marginal rate of about 39%, according to Business Today's report on the IVCA's requests.
• Category III AIF taxation has no dedicated regime. The same report describes private-trust rules that produce "inconsistent interpretations", prolonged disputes and potential double taxation. The Delhi High Court ruling helps, but it is one court and one set of facts.
• 39% or 42.744%? Which surcharge feeds into the maximum marginal rate for an AIF trust is read differently by different advisers.
• Exits and expenses. How a transfer or redemption of your units is taxed, and whether fund expenses and management fees reduce the income allocated to you, depend on the fund's documents and your facts. Get both answers in writing.
• Non-residents. Treaty relief, TDS at "rates in force" and home-country credit all vary by country.

These are reasons to stop asking "is AIF tax free" and start asking what a specific fund will cost you after tax.

Knowing the AIF tax rules turns a vague worry into a short checklist for the fund and your adviser.

1. Which category is the fund registered under, and is it a trust, a company or an LLP?
2. What kind of income does it expect to earn: long-term gains, short-term gains, interest, dividends or business income?
3. For a Category III fund, is the trust treated as determinate, and what rate has the fund actually paid in the last two years?
4. Are quoted returns before or after fund-level tax, and before or after the tax I will pay myself?
5. When will I receive my statement of income, and will I be taxed on amounts credited but not distributed?
6. Can losses pass to me, given the date I am entering?
7. How are transfers and redemptions of units treated, and what does the fund's tax note say about it?

A fund that answers these in writing is easier to live with. One that answers "don't worry, it's tax free" has told you something too.

Is AIF tax free? No, and the three half-truths behind the claim are now easy to separate.

Category I and II funds have pass-through status under Section 115UB, now section 224. The fund is exempt on investment income, you are taxed on it at your own rates, 10% is deducted at source, and you may owe tax before cash arrives. Category III funds pay tax themselves under trust law, at rates that run from capital gains rates to the maximum marginal rate depending on the strategy and the reading of the trust. GIFT City exemptions exist for qualifying funds whose units are held by non-residents.

The 2024 rate changes, the 2025 capital-asset fix, the Delhi High Court ruling and the 2026 renumbering moved the details. They did not create an "AIF tax free" product.

Use PMS Sahi Hai's category pages and Nyra to get the structure of a fund straight, then take the seven checks to the manager and to a tax adviser. Judge every AIF on what you keep after fees and tax, not on the headline number.

Before you sign a contribution agreement, write down three things: the fund's category, the kind of income it will earn, and who pays the tax. If you cannot fill in all three, you are not ready to invest.

PMS Sahi Hai can help with the first two. Browse the tracked AIFs, ask Nyra for a source-cited read on a fund's category and structure, or book a private consultation to go through a shortlist. Take the third to a chartered accountant, along with the fund's tax note and the seven checks above. The answer to "is AIF tax free" is no. The better question is how much of the return will be yours to keep.

This article is for general information as on 5 October 2026 and is not tax, legal or investment advice. Tax outcomes depend on your residential status, income and the fund's documents. Investments in securities markets are subject to market risks.