What does pass-through taxation mean?
Pass-through taxation means that the income earned by the fund is not taxed at the fund level but is instead taxed in the hands of the investors. The fund merely acts as a conduit, passing the income to its investors, who then pay tax based on their individual tax rates and the nature of income received (e.g., capital gains, interest, dividends).
How is income taxed in Category I and Category II AIFs?
For Category I & II AIFs, pass-through taxation applies, meaning income (except business income) is taxed at the investor level:
Capital Gains Tax:
- LTCG: 20% with indexation.
- STCG: 15%.
- Surcharge & cess apply additionally.
Business Income: Taxed at 42.74% (MMR) at the fund level.
Dividend & Interest Income: Taxed at the investor’s slab rate.
No DDT (Dividend Distribution Tax); TDS of 10% applies on income distributions.
What tax applies to business income in Category I and II AIFs?
In Category I & II AIFs, business income is taxed at the fund level at the maximum marginal rate (MMR) of 42.74%. This rate includes:
- Base tax rate: 30%
- Surcharge: 37% (for income above ₹5 crore)
- Cess: 4%
Since business income is not eligible for pass-through status, investors receive post-tax distributions from such income.
How is Category III AIF taxed?
This category of funds is taxable at the fund level. This has no pass-through status. The highest rate of tax (as per the current tax slab) is charged on the profit made by this fund.
A Category III AIF pays tax on the following four types of incomes:
- Short-term capital gains
- Long-term capital gains
- Business income
- Dividend income
Here is a table explaining how each source of income is taxed in category III AIF in India:
| 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% |
Are there any deductions for tax paid on Category III AIF income?
No, investors in Category III AIFs cannot claim deductions for the tax paid at the fund level. Since these funds are taxed at the fund level, any income distributed to investors is already post-tax, and no further tax is levied on them.
Additionally:
- Investors cannot claim a credit or set off the tax paid by the fund against their personal tax liability.
- There is no pass-through benefit, unlike in Category I & II AIFs.
What is the surcharge on AIF taxation?
The surcharge on AIF taxation depends on the type of AIF, income type, and investor category. Here’s how it applies:
1. Category I & II AIFs (Pass-Through for Investors)
- Capital Gains & Other Income (taxed at the investor level)
- Individuals, HUFs, Firms:
- ₹50 lakh – ₹1 crore: 10%
- ₹1 crore – ₹2 crore: 15%
- ₹2 crore – ₹5 crore: 25%
- ₹5 crore & above: 37% (for STCG, interest income)
- For LTCG (Section 112A & 111A):
- Capped at 15%, even for higher income brackets.
- Individuals, HUFs, Firms:
- Business Income (Taxed at Fund Level): 42.74% (MMR), including
- 30% base tax + 37% surcharge (for income >₹5 crore) + 4% cess
2. Category III AIFs (Taxed at Fund Level)
- Business Income & STCG on Unlisted Shares:
- ₹50 lakh – ₹1 crore: 10%
- ₹1 crore – ₹2 crore: 15%
- ₹2 crore – ₹5 crore: 25%
- ₹5 crore & above: 37%
- LTCG (Listed Equity, Debt, etc.):
- Surcharge capped at 15%
Do AIFs have to pay Dividend Distribution Tax (DDT)?
No, AIFs do not have to pay Dividend Distribution Tax (DDT).
Tax Treatment of Dividends in AIFs
Category I & II AIFs:
- Dividends received by the fund are passed through to investors.
- Investors pay tax at their applicable income tax slab rate.
- TDS of 10% is deducted by the AIF before distributing dividends to investors.
Category III AIFs:
- Since Category III AIFs are taxed at the fund level, dividends received are taxed at MMR (up to 42.74%) before distribution.
- Investors receive post-tax dividends, with no additional tax liability.
What is the Maximum Marginal Rate (MMR) applied to business income in AIFs?
The Maximum Marginal Rate (MMR) applied to business income in AIFs is 42.74%.
Breakdown of MMR (for individuals, HUFs, and firms):
- Base Tax Rate: 30%
- Surcharge: 37% (for income above ₹5 crore)
- Cess: 4% (on tax + surcharge)
Application of MMR in AIFs:
Category I & II AIFs:
- Business income is taxed at 42.74% at the fund level.
- Other income (capital gains, dividends, interest) enjoys pass-through taxation and is taxed at the investor’s level.
Category III AIFs:
- All income, including business income, is taxed at the fund level at MMR (42.74% for individuals/HUFs, 34.94% for domestic companies).
- Investors receive post-tax distributions.
