NISM Series XIX-C · Chapter 16: Taxation

L1 · Foundation

Foundation — The pass-through for Category I and II AIFs

The four sections that govern Category I and II taxation, what pass-through does and does not cover, why business income is taxed at fund level, the Finance Act 2025 amendment making AIF securities capital assets, the loss rules, and the five principles of taxation in a unitholder's hands.

24 min read · Worth 13% of the paper · Written from pages 447–486 of the official NISM workbook · Updated 18 September 2026

16.1 Where the tax charge falls

In respect of investors, the basis of charge under Income Tax Act, 1961 (the ITA) depends upon the RESIDENTIAL STATUS of the taxpayer during a tax year, as well as the NATURE OF THE INCOME earned.

A person (natural or juridical) who is a RESIDENT in India is liable to taxation in India on WORLDWIDE INCOME, subject to certain tax exemptions/deductions as may be applicable. A person who is treated as NON-RESIDENT for Indian tax purposes is generally subject to tax in India only on such person's INDIAN-SOURCED INCOME or income accrued, received or deemed to be accrued or received in India.

Resident: worldwide income. Non-resident: Indian-sourced income only. That single distinction runs through the whole chapter.

16.1.1 Tax at the fund level

AIFs can be in the form of a trust, a limited liability partnership (LLP), a company or a body corporate. MAJORITY OF THE AIFs ARE CONSTITUTED AS A CONTRIBUTORY, DETERMINATE, IRREVOCABLE TRUST under the Indian Trusts Act, 1882.

The four sections to memorise

The taxability of Category I and II AIFs is governed by Section 10(23FBA), 10(23FBB), 194LBB and 115UB (Chapter XII-FB — Special Provisions Relating to Tax on Income of Investment Funds and Income Received from such Funds) of the ITA.

Section	What it does
115UB	Defines 'Investment Fund' and sets the pass-through machinery
10(23FBA)	Exempts non-business income in the hands of the Investment Fund
10(23FBB)	Exempts business income in the hands of the unitholders
194LBB	Withholding by the Investment Fund on income distributed

What an "Investment Fund" is

The term 'Investment Fund' is defined under Section 115UB of the ITA as "any fund established or incorporated in India in the form of a trust or a company or a limited liability partnership or a body corporate which has been granted a certificate of registration as a CATEGORY I OR A CATEGORY II Alternative Investment Fund and is regulated under the SEBI (Alternative Investment Fund) Regulations, 2012... or regulated under the International Financial Services Centres Authority (Fund Management) Regulations, 2022."

Therefore, Category I and II AIFs would enjoy tax pass through status at fund level in case of income other than business income.

What pass-through means

The concept of 'tax pass through' enables ZERO TAX LIABILITY on the income (other than business income) at Investment Fund level. The income generated by the Investment Fund, other than business income, will be taxable in the hands of the beneficiaries (investors) DIRECTLY AS PER THEIR RESPECTIVE TAX STATUS.

As per section 115UB read with section 10(23FBA) of the ITA, any income (other than business income) earned by an Investment Fund is EXEMPT IN ITS HANDS and is chargeable to income tax directly in the hands of its investors IN THE SAME MANNER AS IF IT WERE THE INCOME ACCRUING OR ARISING TO, OR RECEIVED BY, SUCH INVESTORS HAD THE INVESTMENTS BEEN MADE DIRECTLY BY THEM.

That phrase — as if the investments had been made directly by them — is the heart of pass-through. The fund is transparent; the investor is taxed as though he had bought the shares himself.

Business income breaks the pass-through

As far as business income is concerned, section 115UB read with section 10(23FBB) of the ITA states that such business income accruing or arising to or received by an Investment Fund is TAXABLE AT THE FUND LEVEL at: (a) the SPECIFIED RATE in Finance Act of the relevant year (where such fund is a COMPANY OR FIRM); (b) the MAXIMUM MARGINAL RATE (MMR) (IN OTHER CASES); and is therefore EXEMPT IN THE HANDS OF THE INVESTORS.

The workbook defines MMR in a footnote: "maximum marginal rate" means the rate of income-tax (including surcharge on income-tax, if any) applicable in relation to the highest slab of income in the case of an individual, association of persons or, as the case may be, body of individuals as specified in the Finance Act of the relevant year.

The mirror image is the point to remember: NON-business income is exempt at FUND level and taxed in the INVESTOR's hands. BUSINESS income is taxed at FUND level and exempt in the INVESTOR's hands. Each rupee is taxed once, but at different places.

Losses

As per section 115UB of the ITA, any BUSINESS LOSS at the fund level is NOT ALLOWED TO BE PASSED THROUGH to its investors but is permitted to be CARRIED FORWARD FOR SET-OFF AGAINST INCOME OF SUBSEQUENT YEAR/(S) BUSINESS INCOME.

LOSS (OTHER THAN BUSINESS LOSS) shall be allowed to be PASSED THROUGH to the investors and allowed to be carried forward and set-off in the hands of the investors of the AIF WHERE THE INVESTORS HAVE HELD THE UNITS OF THE AIF FOR AT LEAST 12 MONTHS.

Business losses stay at the fund. Other losses pass through — but only if the investor has held units for at least 12 months.

Capital gains versus business income

A determination of whether the securities are held as CAPITAL ASSETS or as STOCK-IN-TRADE is a mixed question of law and fact and would depend on the facts and circumstances of each particular case, and upon whether the activities of the Fund could be regarded as amounting to the carrying on of a business or profession.

In view of the above stated ambiguity, there was a LONG STANDING CONTROVERSY on the aspect of capital gains versus business income in the case of Category I and II AIFs... The controversy pertained to whether gains on the sale or transfer of securities by Category I and Category II AIFs, are taxable as business income of such fund or as capital gains accruing to tax in the hands of the underlying investors.

The Finance Act 2025 fix

The ITA was amended by the FINANCE ACT 2025 to remove the ambiguity... SECTION 2(14) of ITA which defines a 'CAPITAL ASSET' (the transfer of which is subject to capital gains tax), was amended to specifically include SECURITIES DEALT WITH BY SEBI / IFSCA (in an IFSC which currently is in GIFT City) REGISTERED CATEGORY I AND II AIFs.

As a result of this amendment, securities held by such AIFs will be treated as CAPITAL ASSETS. Therefore, any income arising from the transfer of such securities would be taxed under the head CAPITAL GAINS AND NOT BUSINESS INCOME with effect from the financial year starting APRIL 1, 2025. Since the word securities is widely defined under law, it would include ALL TYPES OF EQUITY AND DEBT SECURITIES (LISTED AND UNLISTED) that Category I and II AIFs deal with.

This is the single most important recent change in the chapter. From 1 April 2025, transfers of securities by Category I and II AIFs give CAPITAL GAINS — which pass through — not business income, which would have been taxed at the fund at MMR.

Income in the nature of business income shall be taxed in the hands of the Investment Fund under the head 'Profits and gains from business or profession' and it shall be exempt in the hands of the unit-holders under Section 10(23FBB). If Investment fund is a COMPANY OR A FIRM, such business income will be taxable at the rates applicable to the company or firm. However, in any other case, where AIF is registered as a TRUST OR ANY OTHER BODY CORPORATE, such income shall be taxed at MAXIMUM MARGINAL RATES.

16.1.2 The five principles of taxation in the unitholder's hands

The ITA provides that income of an Investment Fund other than income characterised as "business income" should be exempt from tax, in the hands of the Investment Fund and should be chargeable to tax directly in the hands of the unitholders as under:

(a) The income shall be chargeable to tax in the hands of the Unitholders IN THE SAME MANNER AS IF IT WERE THE INCOME accruing or arising to, or received by the Unitholder had the investments, made by the Fund been made DIRECTLY by the Unitholder.

(b) The income paid to the Unitholders by the Fund or credited to the account of the Unitholders by the Fund, shall be deemed to be OF THE SAME NATURE AND IN THE SAME PROPORTION in the hands of the Unitholders, as it had been received by or as accrued/arisen to the Fund.

(c) The income accrued/arisen to or received by the Fund in any financial year WHICH HAS NOT BEEN CREDITED to the account of or DISTRIBUTED to the Unitholders SHALL BE DEEMED TO HAVE BEEN CREDITED by the Fund to the account of the Unitholders AT THE END OF THAT FINANCIAL YEAR. Such credit would be made in the same proportion as the Unitholders would have been entitled to receive the income had it been paid in that financial year.

(d) ONCE THE INCOME IS INCLUDED IN THE TOTAL INCOME of the Unitholder in a previous year, on account of having been accrued or arisen in the said previous year, IT SHALL NOT BE INCLUDED IN THE TOTAL INCOME of such person in the previous year in which such sum is ACTUALLY PAID to the Unitholder by the Fund.

(e) If the net computation of total income at the Fund level is a LOSS (not being in the nature of business losses), then such loss should be passed through to its Unitholders for set-off or carry forward... However, in order to be eligible for pass-through of losses, such Unitholders should continue to hold units in the Fund FOR A PERIOD OF AT LEAST 12 MONTHS.

Points (c) and (d) work as a pair and are heavily examined. Undistributed income is DEEMED credited at the financial year end, so the investor pays tax on it even without receiving cash — and when the cash does eventually arrive, it is NOT taxed again. No double taxation, but also no deferral.

The three streams of income

The AIF generally earns income in the following nature from its portfolio investments:

Dividend income
Interest income
Exit gains arising in the form of sale or buy back or transfer of securities held in portfolio entities

Everything in the rest of this chapter is an elaboration of how those three are taxed, for residents and non-residents, at Category I and II and at Category III.

Think of it like this

The glass pipe and the tank

Imagine two ways of moving water from a reservoir to your house.

A glass pipe just carries it. The water arrives with the same character it had at the source — same mineral content, same temperature. Nobody taxes the pipe. That is pass-through: any income (other than business income) earned by an Investment Fund is exempt in its hands and is chargeable to income tax directly in the hands of its investors in the same manner as if it were the income accruing or arising to, or received by, such investors HAD THE INVESTMENTS BEEN MADE DIRECTLY BY THEM.

The workbook reinforces it: the income paid to the Unitholders... shall be deemed to be OF THE SAME NATURE AND IN THE SAME PROPORTION in the hands of the Unitholders, as it had been received by or as accrued/arisen to the Fund. Dividend stays dividend. Long-term capital gain stays long-term capital gain.

A tank is different. Water goes in, gets mixed, and comes out as something the tank owns. The tank is taxed, not you. That is what happens to business income: such business income accruing or arising to or received by an Investment Fund is taxable at the fund level... and is therefore exempt in the hands of the investors.

Category I and II AIFs are a glass pipe for everything except business income, where they become a tank. Category III AIFs are a tank throughout — Category III AIF does not enjoy tax pass through status at the fund level.

Taxed when earned, not when paid

A landlord collects rent through an agent. The agent receives INR 6 lakh in March but only remits it to the landlord in June. When is the landlord taxed?

Under the AIF pass-through, in March.

The income accrued/arisen to or received by the Fund in any financial year which has NOT BEEN CREDITED to the account of or distributed to the Unitholders SHALL BE DEEMED TO HAVE BEEN CREDITED by the Fund to the account of the Unitholders AT THE END OF THAT FINANCIAL YEAR.

That is uncomfortable for an investor — he owes tax on money he has not seen. But the rule has a matching half that protects him from being taxed twice:

Once the income is included in the total income of the Unitholder in a previous year, on account of having been accrued or arisen in the said previous year, it shall NOT be included in the total income of such person in the previous year in which such sum is ACTUALLY PAID to the Unitholder by the Fund.

So the timing is fixed at accrual, and the later cash receipt is tax-free. No deferral, and no double taxation.

The practical lesson for an investor doing cash planning: an AIF can generate a tax liability in a year in which it distributes nothing at all. That is one more reason Chapter 7 warned that investors have to keep available cash resources while invested in these funds.

Twelve months to keep your losses

A fund has a bad year. Two investors each hold INR 5 crore of units and each is allocated a share of the fund's capital loss. One has held his units for fourteen months; the other bought in nine months ago and is now redeeming.

Only the first can use the loss.

Loss (other than business loss) shall be allowed to be passed through to the investors and allowed to be carried forward and set-off in the hands of the investors of the AIF WHERE THE INVESTORS HAVE HELD THE UNITS OF THE AIF FOR AT LEAST 12 MONTHS.

And note that business loss never passes through at all: any business loss at the fund level is not allowed to be passed through to its investors but is permitted to be carried forward for set-off against income of subsequent year/(s) business income.

Why the twelve-month condition? Because without it, an investor could buy into a loss-making fund shortly before year end purely to acquire a tax loss, and exit immediately afterwards. The holding requirement makes the loss belong to someone who actually bore the economic risk.

The asymmetry is worth noticing and remembering: income passes through from day one; losses only after twelve months.

The 2025 amendment that ended a decade of argument

For years, when a Category II AIF sold a stake in an investee company, two answers were possible and the difference was enormous.

If the gain were capital gains, it passed through and each investor paid at his own rate — perhaps 12.5 per cent on a long-term gain. If it were business income, the fund itself paid at the maximum marginal rate, and the investors got the balance tax-free but very much smaller.

There was a long standing controversy on the aspect of capital gains versus business income in the case of Category I and II AIFs given the nature of their activities. And the test was hopeless to predict: a determination of whether the securities are held as capital assets or as stock-in-trade is a mixed question of law and fact and would depend on the facts and circumstances of each particular case.

The Finance Act 2025 ended the argument by changing the definition itself. Section 2(14) of ITA which defines a "capital asset"... was amended to specifically include securities dealt with by SEBI / IFSCA registered Category I and II AIFs. As a result... any income arising from the transfer of such securities would be taxed under the head capital gains and not business income WITH EFFECT FROM THE FINANCIAL YEAR STARTING APRIL 1, 2025.

And the reach is complete: since the word securities is widely defined under law, it would include all types of equity and debt securities (listed and unlisted) that Category I and II AIFs deal with.

One amendment, and the pass-through works as investors always assumed it did.

Four sections, four jobs

Candidates lose marks confusing the four provisions that govern Category I and II taxation. Each does exactly one job.

Section 115UB is the machinery. It defines "Investment Fund" and sets out how income flows to unitholders in the same character and proportion.

Section 10(23FBA) exempts non-business income at the FUND, so the pass-through can operate.

Section 10(23FBB) exempts business income in the UNITHOLDER's hands, because the fund has already paid on it.

Section 194LBB handles withholding — the fund deducts 10 per cent for residents, and for non-residents 20 per cent on dividend with rates in force on other income.

A way to hold them together: the two 10(23) sections are the two exemptions, and they point in opposite directions — one exempts the fund, the other exempts the investor, and between them each rupee is taxed exactly once. 115UB is the rulebook that makes the arrangement work, and 194LBB is the tax collector standing at the door.

They appear as a set in the PPM too: Chapter 13 required Section XI to disclose the tax regime as per the provisions of section 10(23FBA), section 10(23FBB), 194LBB and section 115UB of the Income Tax Act, 1961.

Resident, non-resident and the passport that matters

Two investors buy identical units in the same Indian AIF on the same day. One lives in Pune, the other in Dubai. Their tax outcomes differ from the first rupee.

A person who is a resident in India is liable to taxation in India on WORLDWIDE INCOME... A person who is treated as non-resident for Indian tax purposes is generally subject to tax in India only on such person's INDIAN-SOURCED INCOME or income accrued, received or deemed to be accrued or received in India.

For the non-resident, a second document then enters the picture. The taxation of non-resident investors is governed by the provisions of the ITA, READ WITH the provisions of the Treaty between India and the country of residence... As per section 90(2) of the ITA, the provisions of the ITA would apply TO THE EXTENT THEY ARE MORE BENEFICIAL than the provisions of the Treaty.

The taxpayer gets whichever is kinder — but not for free, and not unconditionally. In order to claim Treaty benefits, the non-resident is required to obtain a TAX RESIDENCY CERTIFICATE (TRC) issued by the foreign tax authority, together with Form No. 10F where the TRC does not carry the required particulars.

And the whole arrangement sits subject to General Anti Avoidance Rule (GAAR) provisions and provision of Multilateral Instrument. A treaty is a shield, not a magic wand — and a paper company in a treaty country that lacks commercial substance will find the shield taken away.

Key terms in this chapter

Bonus stripping: Where units are bought within three months before a record date and the original units sold within nine months after it while retaining the bonus units, the loss is ignored and added to the cost of the bonus units. It has covered AIF interests since 1 April 2022.
Carry forward periods: Business loss other than speculative and capital loss may be carried forward for eight years; speculative business loss for four years. Carried-forward capital losses remain subject to the long-term against long-term restriction.
Conversion is not a transfer: Conversion of preference shares or debentures into equity of the same company is not a transfer, so no capital gains arise. The original cost becomes the cost of the equity shares and the pre-conversion holding period is included.
Deemed credit of undistributed income: Income accrued to the fund but neither credited nor distributed is deemed credited to unitholders at the end of that financial year, and is not taxed again when actually paid.
Determinate trust: A trust whose beneficiaries are identifiable and whose individual share of income is ascertainable as on the date of the indenture of trust — or where the trust deed specifies categories of beneficiaries and a methodology for determining shares.
Form 64C and Form 64D: Form 64C is the statement of income paid or credited, furnished to the unitholder by 30 June of the following financial year. Form 64D is the corresponding statement filed electronically with the jurisdictional Principal Commissioner by 15 June, under digital signature and verified by a practising CA.
GAAR tainted elements: An arrangement whose main purpose is a tax benefit becomes impermissible if it creates non-arm's-length rights or obligations, misuses or abuses the ITA, lacks commercial substance, or is carried out in a manner not normally employed for bona fide purposes.
Intra-head and inter-head set off: Section 70 permits set off within a head — long-term capital loss only against long-term gains, while short-term loss may go against both. Section 71 permits set off across heads, but capital gains losses may not be set against any other head and business loss may not be set against salaries.
Investment Fund (Section 115UB): A fund established or incorporated in India as a trust, company, LLP or body corporate holding a Category I or Category II AIF registration under the SEBI AIF Regulations or the IFSCA Fund Management Regulations, 2022. Only such funds get pass-through status.
Limitation of Benefit (LOB) clause: A treaty provision restricting benefits to genuine residents. Where avoidance is sufficiently addressed by an LOB clause in a tax treaty, GAAR shall not be invoked.
Market Linked Debentures (MLDs): Instruments whose gains on transfer, redemption or maturity on or after 1 April 2023 are deemed short-term capital gains irrespective of holding period. The same deeming applies to Specified Mutual Funds acquired on or after 1 April 2023 and to unlisted bonds and debentures from 23 July 2024.
MAT and AMT: Minimum Alternate Tax at 15 per cent of book profits for domestic companies, and Alternate Minimum Tax at 18.5 per cent of adjusted total income for non-corporates (15 per cent for co-operative societies), with credit carried forward for 15 years.
Maximum Marginal Rate (MMR): The rate of income tax, including surcharge, applicable to the highest slab of income for an individual, association of persons or body of individuals as specified in the Finance Act of the relevant year.
Multilateral Instrument (MLI): The instrument under Action Plan 15 of the OECD BEPS project, signed by India on 7 June 2017 covering 93 treaties, ratified on 25 June 2019 and in force from 1 October 2019. Its application depends on the positions of both treaty partners.
Representative Assessee (Section 161): The trustee of a determinate irrevocable trust, assessed and taxed in the like manner and to the same extent as the beneficiaries would have been, so that the beneficiaries' rates and mechanism apply.
Revocable transfer: A transfer whose document provides for re-transfer of income or assets to the transferor, or gives the transferor a right to reassume power over them. Sections 61 to 63 then tax the beneficiaries on the attributable income.
Section 10(23FBA): Exempts income other than business income in the hands of the Investment Fund, enabling the pass-through to operate.
Section 10(23FBB): Exempts, in the hands of unitholders, business income that has already been taxed at the Investment Fund level.
Section 111A: Taxes short-term capital gains on listed equity shares and equity-oriented fund units on which STT is paid at 20 per cent, raised from 15 per cent for transfers on or after 23 July 2024.
Section 112A: Taxes long-term capital gains on listed equity shares and equity-oriented fund units where STT is paid at 12.5 per cent without indexation, on gains exceeding INR 1,25,000 in a financial year.
Section 115BAC(1A): The default regime under the Finance Act 2023, which caps surcharge at 25 per cent instead of 37 per cent. A taxpayer with business income may opt back into it only once; others may exercise the option every year.
Section 115QA buyback tax: For buybacks on or before 30 September 2024, the domestic company paid distribution tax at 20 per cent and the shareholder was exempt under Section 10(34A). From 1 October 2024 the company pays nothing and the shareholder is taxed instead.
Section 161(1A): Where the income of a determinate trust consists of or includes profits and gains of business, the WHOLE of the trust's income becomes taxable in the trustee's hands at the maximum marginal rate.
Section 164: Taxes the entire income of an indeterminate trust at the maximum marginal rate in the trustee's hands as representative assessee, though concessional capital gains rates may take precedence.
Section 166: Permits the tax authorities to assess income directly in the beneficiaries' hands if not already assessed on the trustee, with credit for any tax the trustee has paid.
Section 194LBB: Requires an Investment Fund to withhold tax on income distributed — 10 per cent for residents on all non-business income, 20 per cent for non-residents on dividend and rates in force on other income.
Section 2(14) amendment (Finance Act 2025): Extends the definition of capital asset to securities dealt with by SEBI or IFSCA registered Category I and II AIFs, so that from 1 April 2025 gains on their transfer are capital gains rather than business income.
Section 50CA: Where unquoted shares are transferred below fair market value, the FMV is deemed to be the full value of consideration for computing capital gains. FMV of unlisted equity comes from book values; of other securities from market value certified by a merchant banker or CA.
Section 56(2)(x): Where a person receives property including securities for a consideration below fair market value by more than INR 50,000, the difference is taxable in the recipient's hands as Income from Other Sources.
Section 90(2): The rule that the provisions of the ITA apply only to the extent they are more beneficial than the treaty, subject to GAAR and the MLI.
Securities Transaction Tax (STT): Levied on exchange transactions — 0.1 per cent each side on delivery-based equity, 0.025 per cent on non-delivery sales, 0.1 per cent on sale of options with 0.125 per cent on exercise, 0.02 per cent on sale of futures, and 0.2 per cent on offers for sale of unlisted shares or business trust units.
Stamp duty on AIF units: From 1 July 2020, 0.005 per cent on issue and 0.015 per cent on transfer of units, paid by the fund on behalf of investors, with no stamp duty on redemption.
Tax pass through: Zero tax at the Investment Fund level on income other than business income, which is instead taxed directly in investors' hands as if the investments had been made directly by them.
Tax Residency Certificate (TRC): A certificate issued by the foreign tax authority that a non-resident must obtain to claim treaty benefits, supplemented by Form No. 10F where the TRC does not carry the prescribed particulars.

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Original explanatory writing based on the official NISM workbook for Series XIX-C, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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