Category I and II get pass-through taxation. Category III does not. That single difference drives investor decisions and should drive your fund structuring.
Category I and Category II AIFs receive pass-through status on income other than business profits. This means the fund itself is not taxed on capital gains, interest, or dividend income. Instead, the income retains its character and passes through to investors, who are taxed based on the nature of the income and their own tax status [1][2]. A domestic HNI, a foreign institutional investor, and a tax-exempt endowment will all pay different rates on the same fund distribution, because the income flows through to them as if they had earned it directly.
Category III AIFs do not receive pass-through treatment on capital gains [1][2]. The fund itself is treated as the taxpayer for capital gains purposes. It pays tax at the applicable rate, and then distributes post-tax proceeds to investors. Those distributions are exempt in the investors' hands to avoid double taxation, but the fund-level tax rate is often higher than what certain investors would have paid individually, particularly non-residents, tax-exempt entities, or investors in lower tax brackets.
This is the single most important tax distinction in the Indian AIF space. Every structuring decision downstream flows from it.
How capital gains are taxed in Category I and II AIFs
Under the pass-through regime, capital gains from Category I and II AIFs are taxed in the investor's hands as follows [1][2]:
Long-term capital gains on unlisted securities (held for more than 24 months): taxed at 12.5% for most investor categories, following standardisation through recent Finance Act amendments [1]. This rate applies to both domestic and foreign investors, though treaty benefits may reduce the effective rate for certain non-residents.
Short-term capital gains on unlisted securities (held for less than 24 months): taxed at the investor's applicable income tax slab rate. For domestic individuals in the highest bracket, this can be 30% plus surcharge and cess. For corporates, the rate depends on the company's total income and applicable surcharge.
Listed security gains (if the fund holds any within its permitted allocation): follow the standard listed equity tax regime: 12.5% long-term (holding period over 12 months) and 20% short-term, with the first INR 1.25 lakhs of LTCG exempt for individual investors [1].
Dividend income: Taxed at the investor's applicable rate. Since the abolition of the Dividend Distribution Tax (DDT) in 2020, dividends are taxable in the investor's hands at their marginal rate.
Interest income: Taxed at the investor's applicable rate. For non-residents, withholding tax applies at the time of distribution, typically at 20% (or the treaty rate, whichever is lower) [3].
The business income exception
Here is where it gets tricky. Even in Category I and II AIFs, if any income is classified as "business income" rather than "investment income," it is taxed at the fund level, not passed through [1][2]. Most managers do not realise how much this matters.
If SEBI or the Income Tax department determines that your fund's activities constitute a business (for example, because of the frequency of trading, the nature of income sources, or the fund's stated objectives), that income gets taxed at the maximum marginal rate at the fund level. It then passes to investors as exempt income. The problem: the fund-level rate (typically around 42.7% including surcharge and cess for non-corporate entities) may be much higher than what individual investors would have paid.
For venture capital funds making long-term equity investments in startups, business income classification is usually not a risk. But if your fund also earns consulting fees, receives management fees at the fund level (rather than the manager entity), or engages in activities that could be construed as business operations, consult a tax advisor early. The classification is fact-specific and the stakes are high.
Category III: how fund-level taxation works
Category III AIFs face a different regime entirely [1][2]. Capital gains are taxed at the fund level. The fund pays the applicable tax on realised gains before distributing to investors. Distributions to investors are then exempt to prevent double taxation.
The issue is the rate. A Category III AIF structured as a trust (the most common structure) pays capital gains tax at the maximum marginal rate applicable to the trust. For short-term capital gains on listed equities, that is 20%. For long-term gains, it is 12.5%. But for unlisted securities and other asset classes, the effective rate can be much higher than what a pass-through structure would achieve for most investors [1][4].
That is why Category III seldom makes sense for a venture capital or private equity strategy. The tax drag at the fund level reduces net returns compared to a Category I or II structure holding the same investments. Category III makes sense when the strategy requires leverage, active trading in listed markets, or derivative overlay (features that Category I and II do not permit).
Foreign investors: withholding tax and treaty benefits
Raising capital from non-resident investors adds a layer of tax complexity that many first-time managers underestimate [3].
When a Category I or II AIF distributes income to a non-resident investor, the fund (or its manager/trustee) is required to withhold tax at the applicable rate before remitting the distribution [3]. The withholding rate depends on the nature of the income:
- Long-term capital gains on unlisted securities: 12.5%, subject to treaty benefits.
- Short-term capital gains: 30-40% depending on the investor's tax status and applicable surcharge.
- Interest income: Typically 20% under domestic law, potentially reduced under a Double Taxation Avoidance Agreement (DTAA) [3].
- Dividend income: Taxed at 20% for non-residents under domestic law, subject to treaty rates.
Treaty benefits can substantially reduce the effective tax rate for investors from jurisdictions with favourable DTAAs (Singapore, Mauritius, Netherlands, among others). But claiming treaty benefits requires proper documentation: tax residency certificates, beneficial ownership declarations, and compliance with the relevant treaty's Limitation of Benefits provisions. Your fund administrator needs to manage this documentation process for each non-resident LP.
GIFT City: the special regime
AIFs registered in the International Financial Services Centre (IFSC) at GIFT City, Gujarat, operate under a distinct tax regime administered by IFSCA [4][5]. The headline benefit: capital gains earned by non-resident investors through GIFT City AIFs are exempt from Indian taxation under Section 10(4D) of the Income Tax Act [4][5].
This makes GIFT City attractive for fund managers raising primarily from offshore investors. But domestic Indian investors do not get the same benefit; they are still taxed on income from GIFT City funds. The GIFT City regime also comes with its own regulatory framework under the IFSCA (Fund Management) Regulations, 2025 [5], which differs from the SEBI AIF Regulations in several ways.
For an emerging manager whose LP base is primarily domestic Indian capital, the GIFT City structure offers limited tax advantage. For managers with significant offshore commitments, it is worth serious consideration, though the setup and compliance costs are different from a standard onshore AIF.
What your investors will ask and how to answer
Based on the fundraises I have participated in, here are the tax questions that come up in almost every LP meeting:
"What is my effective tax rate on a 3x exit from a startup held for 4 years?" For a Category I or II AIF: the gain is long-term capital gain on unlisted securities, taxed at 12.5% in the investor's hands (assuming they are a domestic individual) [1]. The answer changes for different investor types.
"How are capital calls and distributions reported for tax purposes?" The fund issues annual income certificates to each investor specifying the nature and amount of income allocated to them. Investors use this to file their own tax returns. The fund does not file returns on behalf of investors, but it does file TDS (Tax Deducted at Source) returns for non-resident investors [3].
"What happens if the fund earns interest on idle cash between capital calls?" Interest income passes through to investors and is taxed at their marginal rate. For investors in the highest bracket, this can be over 30%. Some managers address this by keeping idle capital deployment periods short or using money market instruments with specific tax treatment.
If you cannot answer these questions clearly and specifically for your fund's structure, you will lose investors. Tax efficiency is not a bonus feature. It is a baseline expectation from sophisticated LPs.
How Allocator One Bharat and Infra One handle tax reporting
At Allocator One Bharat, we build tax reporting into the fund administration workflow from day one. Our platform tracks the character of each income stream at the portfolio level, calculates investor-level allocations based on their commitment and drawdown history, generates annual income certificates, and manages TDS obligations for non-resident investors.
We work with tax advisors across jurisdictions to ensure that treaty benefits are properly documented and applied. For emerging managers who do not have an in-house tax team, we handle the operational complexity of multi-investor, multi-jurisdiction tax reporting so you can focus on investing. If you want to talk through how tax structuring should inform your fund design, reach out.
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