Taxation of AIFs in India

Introduction: What Are AIFs?

In recent years, Alternative Investment Funds (or AIFs) have received immense traction and attention from HNI investors. And this impact is visible in the number of AIF investments. It has reached Rs 15,05,372 crores (USD 15.05 billion) in September 2025, and continues to do so.

But what concerns investors is the returns achievable on these investments and how much tax they might have to pay. And your questions end here!

Keep reading as we explore the meaning of AIFs, categories of AIF, and the related AIF taxation applicable in India.

So, whether you're a first-time investor or have already invested in AIFs, this blog will answer your AIF tax-related queries.

What Are AIFs?

Alternative Investment Funds are private investments that actually pool money from investors and invest in private equity, venture capital, or trading strategies. It has three categories: Cat 1 AIF, Cat 2 AIF, and Cat 3 AIF.

Even when products like Mutual funds, SIFs, and PMS exist, AIFs have their own reasons to be introduced.

One of the primary reasons for introducing AIFs is the ticket size of ₹1 crore and the instruments it invests in. While a mutual fund invests in stocks, bonds, or commodities, the AIF engages in positions and assets that are usually not possible in MFs.

Types of AIF Categories Available

Based on the type of instrument invested in, there are three main categories of AIFs.

Cat 1 AIF

• This category of AIFs primarily invests in growth-driven companies, small and medium-sized enterprises (SMEs), social ventures, venture capital, and infrastructure funds.
• Here, the minimum tenure is at least 3 to 5 years, depending on the fund type.
• Cross-investments are allowed in all sub-types, except for "Fund-of-Funds" in the same category.
• Also, leveraging or borrowing money is not allowed except for short-term borrowings.

Cat 2 AIF

• Unlike Category I, Category II AIFs invest more in private equity and debt funds.
• They also invest in distressed asset funds, real estate funds, debt funds, and fund-of-funds.
• These funds maintain a minimum lock-in tenure of three years and are hence referred to as "closed-ended." However, they have a varying tenure of 5–8 years, depending on the scheme.

Cat 3 AIF

• The last category of AIFs (i.e., Cat 3 AIFs) invests in hedge funds, listed and unlisted companies, derivatives, complex and structured products, commodity derivatives, and other similar assets.
• It involves the active involvement of fund managers when dealing with derivatives or trading strategies.
• These funds can be open-ended or closed-end, as per the fund structure and scheme.

Taxation of AIFs in India

For each category, different AIF taxation rules apply. Just keep in mind that investors shall pay tax on income in Cat 1 & 2 AIFs (in short, the pass-through status applies). Like a bypass, the fund does not tax at the fund level, except for business income.

While for Cat 3 AIF, there is no pass-through status available. In other words, the fund will pay taxes on all its income, and the investor will receive post-tax returns.

The table below simplifies the tax rules for you.

AIF Category	Tax Status	Investor Income (Non-Business)	Business Income (Fund Level)
Category I	Pass-through (except business income)	Taxed in the hands of investors. Gains are taxed at 12.5% for retail and standard rates apply for foreign investors.	Taxed at the fund level (30% for residents, up to 39% for non-residents).
Category II		Pass-through (same as Category I).
Category III	No pass-through (fund taxed)	Investors receive post-tax returns. Company: Dividends with TDS LLP: Distributions exempt Trust: Income may be taxed at the trustee/investor level.	Taxed at the fund level: Company: Corporate tax rates. LLP: LLP-level tax Trust: Max marginal rate on business income.

Conclusion

Alternative Investment Funds have opened the door for more investors to participate in private markets within a regulated framework. With three categories to choose from, investors can pick the one that aligns with their strategy and risk appetite.

However, before investing, it's equally important to understand the AIF taxation rules that apply to each category. At times, these AIFs may come with lock-in requirements and other terms that can affect your return potential. Hence, do consider consulting a financial advisor to ensure you select the AIF type that best suits your investment goals.

[Disclaimer: The information provided in this article is for educational and informational purposes only. Any financial figures, calculations, or projections shared are solely intended to illustrate concepts and should not be construed as investment advice. All scenarios mentioned are hypothetical and are used only for explanatory purposes. The content is based on information obtained from credible and publicly available sources. We do not guarantee the completeness, accuracy, or reliability of the data presented. Any references to the performance of indices, stocks, or financial products are purely illustrative and do not represent actual or future results. Actual investor experience may vary. Investors are advised to carefully read the scheme/product offering information document before making any decisions. Readers are advised to consult with a certified financial advisor before making any investment decisions. Neither the author nor the publishing entity shall be held responsible for any loss or liability arising from the use of this information.”]