CHAPTER 13: TAXATION (PART 1 — CORE STATUTORY FRAMEWORK & RESIDENT INVESTOR TAXATION)

1.1 Introduction to the Indian AIF Taxation Landscape

The taxation framework of Alternative Investment Funds (AIFs) in India is designed to balance investment attractiveness with structured tax collections under the Income Tax Act, 1961 (ITA). To understand the tax implications of Category I and Category II AIFs, we must first look at the residential status of the parties involved and the legal structures used to house these investments.

Residential Status & Scope of Income

Under the ITA, the scope of taxable income is determined by the residential status of the assessee (individual or legal entity):

• Resident Investors: Residents in India are liable to pay income tax on their worldwide income, subject to any double taxation avoidance agreements or statutory exemptions.
• Non-Resident Investors: Non-residents are subject to tax in India only on Indian-sourced income or on income that is received, accrued, or deemed to be received/accrued in India. Under FEMA, residency is evaluated based on the "intention of stay," whereas under the ITA, it is strictly evaluated based on the physical duration of stay in India.

Permissible Legal Structures for AIFs

An AIF can be constituted under any of the following four legal forms:

1. Trust: Established under a Trust Deed and registered under the Registration Act, 1908. This is the most common form adopted by Category I and II AIFs in India.
2. Limited Liability Partnership (LLP): Incorporated under a Partnership Deed filed with the Registrar of Companies under the LLP Act, 2008.
3. Company: Formed and registered under the Companies Act, 2013.
4. Body Corporate: Established under a specific Central or State Legislature.

The majority of domestic Category I and II AIFs are established as contributory, determinate, and irrevocable trusts under the Indian Trusts Act, 1882.

1.2 Core Statutory Tax Framework for Category I & II AIFs

Category I and Category II AIFs are governed by a specific regime introduced in Chapter XII–FB of the ITA. The governing sections are Section 10(23FBA), Section 10(23FBB), Section 115UB, and Section 194LBB.

The Tax Pass-Through Concept

Category I and Category II AIFs enjoy a statutory pass-through status for all streams of income other than business income. This means:

• The fund itself is exempt from tax on its non-business income under Section 10(23FBA).
• The non-business income (such as dividends, interest, and capital gains) is taxed directly in the hands of the unitholders (investors) as if they had made the investments directly.
• The income paid or credited to the investors retains its original character and proportion as it had when received by the fund.

Tax Treatment of Business Income

The pass-through status does not apply to income characterised as "Profits and Gains from Business or Profession".

• Fund-Level Taxation: Any business income earned by a Category I or II AIF is taxable at the fund level under Section 10(23FBB).
• Investor Exemption: Once the business tax is paid at the fund level, this income is fully exempt in the hands of the investors.
• Applicable Tax Rates:
  • If the AIF is structured as a Company or Firm (LLP), the business income is taxed at the specified corporate/firm tax rate.
  • If the AIF is structured as a Trust (or other legal form), the business income is taxed at the Maximum Marginal Rate (MMR).

Formula for MMR:
Maximum Marginal Rate (MMR) = Highest slab rate of income tax + Applicable Surcharge + Health and Education Cess

Tax Treatment of Losses

The pass-through mechanics handle losses differently depending on whether they are business or non-business losses:

• Business Losses: Business losses incurred at the fund level cannot be passed through to the investors. They must be retained at the fund level and are allowed to be carried forward for set-off against the fund's business income in subsequent assessment years.
• Non-Business Losses (e.g., Capital Losses): Net capital losses or other non-business losses are passed through to the unitholders. Investors can set off or carry forward these losses in their personal tax returns, provided they have held their units in the AIF for a minimum period of 12 months.

1.3 Characterisation of Income: Capital Gains vs. Business Income

Because business income is taxed at the fund level (often at high rates like the MMR) while capital gains enjoy a pass-through to investors (often at lower tax rates), the characterisation of income from the sale of securities is a critical tax matter.

Guidelines for Determining Income Characterisation

The determination of whether securities are held as "capital assets" (generating Capital Gains) or "stock-in-trade" (generating Business Income) is a mixed question of law and fact. The Central Board of Direct Taxes (CBDT) and judicial precedents require a harmonious evaluation of the following factors:

• Motive of the Purchase: The intention of the AIF manager at the time of acquiring the securities. An investment motive indicates capital assets, while a trading motive indicates stock-in-trade.
• Frequency of Transactions: High-frequency buying and selling over short periods suggests trading (business income).
• Holding Period: Longer holding periods generally substantiate a capital gains characterisation.
• Accounting Treatment: How the securities and corresponding profits or losses are treated in the books of accounts of the AIF.
• Source of Funds: Whether the securities were acquired using owned capital or borrowed funds.
• Object Clause: The existence of an explicit object clause in the constitutional documents (like the Trust Deed or Memorandum of Association) that permits trading in securities.
• Acquisition Method: Whether the securities were sourced from the primary market (e.g., IPO, Private Placement) or secondary market.
• Infrastructure Employed: The scale of administrative infrastructure and systems set up to execute transactions.

The CBDT 12-Month Rule for Listed Securities

To reduce litigation, the CBDT has issued clear guidelines stating that if listed shares or securities are held by an assessee for a period of more than 12 months, and the assessee chooses to treat them as capital assets, the tax department will accept this treatment and will not characterise the gains as business income. However, this safe harbour does not apply to transactions deemed as sham or to unlisted securities.

1.4 Detailed Taxation of Income Streams for Resident Investors

Under the pass-through mechanism, once the net income of the AIF (other than business income) is computed, it is taxable directly in the hands of the resident unitholders.

The Deemed Distribution Rule (Section 115UB(6))

Under Section 115UB(6), even if the non-business income earned by the AIF during a financial year is not actually distributed to the unitholders, it is deemed to have been credited to their accounts on the last day of that financial year (31st March).

• Resident investors must pay tax on this deemed credit in the relevant financial year.
• When the fund actually distributes this income in a subsequent year, no tax is payable on the actual payment to avoid double taxation.

1. Interest Income

• Characterisation: Classified under the head "Income from Other Sources" (IFOS).
• Resident Tax Rate: Taxable at the ordinary slab rates applicable to the individual resident investor (plus applicable surcharge and health and education cess).

2. Dividend Income

• DDT Abolition: Indian portfolio companies are not required to pay any Dividend Distribution Tax (DDT) on dividends distributed or declared.
• Resident Tax Rate: Dividends are taxable directly in the hands of the resident unitholder at their applicable slab rates.
• Section 80M Deduction: If a resident investor is an Indian domestic company, it can claim a deduction under Section 80M for dividends received from the AIF, provided the company distributes equivalent dividends to its own shareholders at least one month prior to the tax filing due date under Section 139.

3. Capital Gains on Listed Equity Shares

The tax rules apply depending on the holding period of the shares:

• Holding Period Threshold: Listed equity shares are classified as Long-Term Capital Assets (LTCA) if held for more than 12 months; otherwise, they are Short-Term Capital Assets (STCA).
• Long-Term Capital Gains (LTCG) [Section 112A]:
  • W.e.f. transfers on or after 23-07-2024, LTCG is taxed at 12.5% without indexation benefits. (Transfers made before this date were taxed at 10%).
  • Resident investors receive an annual exemption of Rs. 1,25,000 on aggregate LTCG. Only gains exceeding this limit are subject to the 12.5% tax.
  • STT Condition: Securities Transaction Tax (STT) must have been paid on both acquisition and transfer (unless the acquisition falls under the list of notified exemptions).
• Short-Term Capital Gains (STCG) [Section 111A]:
  • W.e.f. transfers on or after 23-07-2024, STCG is taxed at 20%. (Transfers made before this date were taxed at 15%).
  • Subject to STT being paid on the transfer.

4. Capital Gains on Unlisted Equity Shares

• Holding Period Threshold: Unlisted equity shares are classified as LTCA if held for more than 24 months; otherwise, they are STCA.
• Long-Term Capital Gains (LTCG): Taxed at 12.5% without indexation benefits.
• Short-Term Capital Gains (STCG): Taxed at the applicable slab rates of the resident investor.

5. Capital Gains on Listed Debentures

• Holding Period Threshold: Listed debentures are classified as LTCA if held for more than 12 months; otherwise, they are STCA.
• Long-Term Capital Gains (LTCG): Taxed at 12.5% without indexation benefits.
• Short-Term Capital Gains (STCG): Taxed at the applicable slab rates of the resident investor.
• Market Linked Debentures (MLDs): Under the Finance Act 2023, any gains arising from the transfer, redemption, or maturity of MLDs are deemed to be short-term capital gains, irrespective of the actual holding period of the instrument.

6. Capital Gains on Unlisted Debentures

The Finance Act, 2024 introduced a major amendment regarding unlisted debt instruments:

• Holding Period Threshold: Historically, unlisted debentures were classified as LTCA if held for more than 36 months, which was reduced to 24 months w.e.f. 23-07-2024.
• The Deemed Short-Term Rule (Finance Act, 2024): W.e.f. transfers, redemptions, or maturities on or after 23-07-2024, any capital gains arising from unlisted debentures or unlisted bonds are deemed to be short-term capital gains, irrespective of the period of holding. Consequently, these are taxed at the resident investor's applicable slab rates.
• Note on historical transfers: If the unlisted debentures were transferred or redeemed before 23-07-2024, the gains were classified as LTCG if held for more than 36 months, taxable at 20% without indexation.

7. Buyback of Shares by a Company

The tax treatment of share buybacks underwent a complete regime shift in 2024:

• Buybacks executed on or before 30-09-2024:
  • Any income arising to a shareholder on account of buyback is fully exempt under Section 10(34A).
  • The domestic company executing the buyback is liable to pay a buyback tax under Section 115QA at the rate of 20% (plus surcharge and cess) on the distributed income.
• Buybacks executed on or after 01-10-2024:
  • The domestic company is no longer liable to pay buyback tax under Section 115QA.
  • The buyback proceeds received by the shareholder/unitholder are directly taxable in the investor's hands. The entire buyback receipt is treated similarly to dividend distribution and taxed at the investor's applicable tax slab.

8. Conversion of Convertible Instruments

• Preference Shares to Equity Shares: The conversion of convertible preference shares into equity shares is not regarded as a transfer under the ITA.
  • No capital gains tax is triggered at the time of conversion.
  • The historical cost of the preference shares is deemed to be the cost of acquisition of the converted equity shares.
  • The holding period of the preference shares is added to the holding period of the equity shares to determine whether they are long-term or short-term when sold.
• Convertible Debentures to Equity Shares: Similarly, the conversion of convertible debentures into equity shares of the same company is not regarded as a transfer.
  • No capital gains are payable at conversion.
  • The acquisition cost of the debenture becomes the cost of the equity shares.
  • The holding period of the debenture prior to conversion is included in the period of holding of the equity shares.

9. Share of Profit from an LLP / Partnership Firm

• Exempt Income: The share of a partner in the total income of an LLP or partnership firm is fully exempt from tax under Section 10(2A).
• Pass-Through Exempt: Accordingly, such profits distributed by the AIF on a pass-through basis to its unitholders are exempt from tax.

10. Transfer of Partnership Interest in LLP / Firm

• Holding Period Threshold: Classified as LTCA if held for more than 24 months (reduced from 36 months w.e.f. 23-07-2024); otherwise, it is STCA.
• LTCG Rate: Taxed at 12.5% without indexation benefits.
• STCG Rate: Taxed at the resident investor's applicable slab rates.

11. Capital Gains on Transfer of AIF Units

When a resident investor exits the AIF by selling or transferring their AIF units to another party, the tax implications depend on how the units were held:

• If characterised as Capital Gains:
  • Listed AIF Units: Classified as LTCA if held for more than 12 months (reduced from 36 months w.e.f. 23-07-2024); otherwise, STCA.
  • Unlisted AIF Units: Classified as LTCA if held for more than 24 months (reduced from 36 months w.e.f. 23-07-2024); otherwise, STCA.
  • LTCG Rate: Taxed at 12.5% without indexation benefits.
  • STCG Rate: Taxed at the investor's applicable slab rates.
• If characterised as Business Income: Net gains (after deducting the cost of purchase and associated transfer expenses) are taxed at the ordinary slab rates of the resident investor.

1.5 Resident Investor Taxation Summary Matrix — 2026

1.6 Key Regulatory Anti-Avoidance & Other Provisions

To ensure robust tax administration, the ITA includes provisions to prevent tax leakage and ensure proper reporting.

Bonus Stripping (Section 94(8))

W.e.f. 1st April 2022, the bonus stripping provisions cover units of AIFs alongside mutual funds and REITs/InvITs.

• The Rule: If an investor buys units of an AIF within 3 months prior to the record date of a bonus issue, gets allotted bonus units without consideration, and subsequently sells all or any of the original units within 9 months after the record date while continuing to hold the bonus units, then any loss arising on the sale of the original units is ignored.
• Treatment: The ignored loss is deemed to be the cost of acquisition of the bonus units held on that date.

Expenditure Incurred on Exempt Income (Section 14A)

If any income earned by the unitholder is exempt from tax (such as the share of profit from an LLP/partnership or buyback proceeds exempt before 30-09-2024), any expenditure incurred directly or indirectly by the investor in relation to earning that exempt income is not allowed as a tax deduction. This rule applies even if no exempt income actually accrued or arose during the relevant previous year.

1.7 Key Terms & Definitions

• Tax Pass-Through: A mechanism where the intermediary (AIF) is ignored for tax purposes on specified streams of income, and the tax liability is shifted directly to the final investors (unitholders).
• Maximum Marginal Rate (MMR): The rate of income tax (including the highest slab rate, applicable surcharge, and cess) applicable to the highest slab of income for an individual, association of persons, or body of individuals as specified in the Finance Act.
• Capital Asset: Property of any kind held by an assessee (whether or not connected with their business or profession), excluding stock-in-trade.
• Securities Transaction Tax (STT): A tax levied on taxable securities transactions executed on a recognised stock exchange in India.
• Indexation Benefit: A process that adjusts the purchase price of an asset to reflect the effect of inflation over the holding period. This benefit has been withdrawn for long-term capital assets transferred on or after 23-07-2024.