NISM Series XIX-E · Chapter 14: Taxation
L1 · FoundationWho Pays the Tax - Trusts, Pass-Through and the Category III Problem
How residence decides what India taxes, why a Category III AIF has no pass-through status, the trust taxation tree - revocable against irrevocable, determinate against indeterminate - the representative assessee, maximum marginal rate, the Investment Fund regime for Categories I and II, and the Finance Act 2025 fix on capital gains versus business income.
18 min read · Worth 8% of the paper · Written from pages 367–387 of the official NISM workbook · Updated 18 September 2026
Who Pays the Tax - Trusts, Pass-Through and the Category III Problem
Tax questions in this exam are rarely about arithmetic. They test who is taxed, under which head, and at what kind of rate. Get the structure right and the rates follow.
The law this chapter uses
The chapter discusses taxation under the Income Tax Act, 2025 (called the ITA) and its subordinate rules. The basic scheme of taxing investors and computation are outside the scope of this workbook.
Tax year means the 12-month period of the financial year starting on 1 April. For a newly set-up business or profession, it runs from the date of setting up to the end of that financial year.
14.1 Residence decides the reach
| Status | What India taxes |
|---|---|
| Resident (natural or juridical person) | Worldwide income, subject to exemptions and deductions |
| Non-resident | Generally only Indian-sourced income, or income accrued, received, or deemed to accrue or be received in India |
14.1.1 The Category III problem - no pass-through
The tax regime for a Category III AIF depends on its legal structure. Most AIFs are set up as a "Trust".
Under the ITA, NO pass-through status has been given to a Category III AIF. So the general principles of trust taxation apply.
This single sentence is the key to the chapter. Categories I and II have a special regime. Category III does not.
14.1.1.1 The trust taxation tree
A trust's tax treatment depends on three questions:
- Is the investor's transfer revocable or irrevocable?
- Are the beneficiaries and their shares known upfront - determinate or indeterminate?
- Does the fund carry on a business?
| Branch | Sections | Who is taxed |
|---|---|---|
| Revocable | Sections 97 and 98 | Income taxed in the hands of the transferor - the contributors or settlor |
| Irrevocable and determinate | Sections 303 to 307; representative assessee under section 304 | The trustee, as Representative Assessee, in the same manner as the beneficiaries |
| Irrevocable and indeterminate | Section 307 | The trustee, at Maximum Marginal Rate (MMR) |
Revocable or irrevocable?
A transfer is REVOCABLE when the contribution agreement provides for:
- re-transfer, directly or indirectly, of all or part of the income or asset to the transferor, or
- any right for the transferor to reassume power over all or part of the income or asset.
If contributions are revocable, the beneficiaries are taxed on the income from them. Typically, Category III AIFs are NOT structured as trusts with revocable transfers.
If the transfer is irrevocable, the next question is whether the beneficiaries' shares are determinate.
Determinate trust - the two conditions
A trust is determinate if:
- The beneficiaries are identifiable on the date of the trust deed; and
- Each beneficiary's share of income is ascertainable on that date.
A trust may still be determinate if the deed names CATEGORIES of beneficiaries and gives a METHOD for working out each share.
What follows for a determinate trust:
- The trustee is assessed as Representative Assessee under section 304.
- Tax is levied in the same manner and to the same extent as on the beneficiaries - their rates and mechanism apply to each share.
- Once taxed in the trustee's hands, there should be no further tax when the income is distributed - subject to MAT for corporate beneficiaries.
- The tax authorities MAY assess the beneficiaries directly if the trustee has not been assessed. Tax already paid by the trustee should be available as credit.
What MMR means
Maximum Marginal Rate is the income-tax rate, including surcharge, for the highest income slab of an individual, AOP or BOI, as set in the Finance Act of the year.
Indeterminate trust
If the trust does not meet the determinate test, the trustee could be taxed at MMR under section 307.
Two views sit side by side in the workbook:
| View | What it says |
|---|---|
| Judicial precedent | A taxpayer may take the view that concessional capital gains rates - 12.5 per cent on STT-paid LTCG (section 198) and 20 per cent on STT-paid STCG (section 196) - take precedence over MMR |
| CBDT Circular No. 13/2014, 28 July 2014 | Where the fund is an indeterminate trust, the ENTIRE income is taxed at MMR in the trustees' hands. Section 307 need not be invoked again in the investor's hands, since the income is already taxed |
14.1.2 Income of a Category III AIF set up as an irrevocable determinate trust
| Income | Tax |
|---|---|
| Profits or gains of business or profession | MMR, plus surcharge and cess |
| Capital gains and income from other sources | The rate applicable to that income, paid by the trustee on behalf of beneficiaries |
The Investment Fund regime - for Categories I and II only
Section 224 read with section 11, Schedule V of the ITA creates a pass-through for an "Investment Fund". Footnote 157: section 224 applies to Category I and Category II AIFs registered with SEBI or IFSCA.
| Item | Treatment |
|---|---|
| Non-business income (Table Sl. No. 1) | Exempt in the fund. Taxed in investors' hands as if they had invested directly |
| Business income (Table Sl. No. 2) | Taxed at fund level - at the rate in the Finance Act if the fund is a company or firm, and at MMR in other cases - and exempt in investors' hands |
| Business loss | NOT passed through. Carried forward at fund level against future business income |
| Other losses | Passed through and carried forward by investors who held units for at least 12 months |
14.1.2.1 Capital gains or business income?
Whether securities are capital assets or stock-in-trade is a mixed question of law and fact. It depends on whether the fund's activities amount to carrying on a business.
For Categories I and II, this caused a long-standing controversy.
The Finance Act 2025 settled it. Section 2(22) of the ITA, which defines "capital asset", was amended to include securities held by SEBI- or IFSCA-registered Category I and II AIFs. So gains on transferring those securities are taxed as capital gains, not business income, from the financial year starting April 1, 2025. Because "securities" is widely defined (under section 2(h) of the SCRA, 1956), this covers equity and debt, listed and unlisted.
Business income, where it still arises, is taxed in the Investment Fund's hands and exempt for unit holders. It is taxed at company or firm rates if the fund is a company or firm, and at MMR if it is a trust or any other body.
Think of it like this
A revocable trust is a locker you kept the key to
If you put your jewellery in your brother's bank locker but keep a duplicate key and the right to take it back, the jewellery is still yours in every real sense. The tax law sees a revocable transfer the same way. Because the contributor can take back the asset or its income, the income is taxed in the hands of the transferor. That is why sections 97 and 98 look through the trust to the person who can reclaim the money.
The trustee as representative assessee is the building secretary paying society bills
In a housing society the secretary pays the water bill for every flat. He is not the one using the water, but he pays in each member's name and at each member's share. A determinate trust works like this. The trustee pays tax as a Representative Assessee, in the same manner and to the same extent as each beneficiary would. Once he has paid, the members are not billed again - though the society can still chase a member directly if the secretary never paid.
Indeterminate trust is the tiffin box with no name on it
In an office pantry, a labelled tiffin goes back to its owner. An unlabelled one is handled by the pantry boy under the strictest rule, because nobody can say whose it is. When a trust deed cannot identify the beneficiaries or their shares, the law cannot apply each owner's own rate. So the trustee pays at the Maximum Marginal Rate, the harshest rate available.
One drop of business income spoils the whole pot of milk
A little curd in a pot of milk turns the whole pot. The workbook warns that if any portion of a trust's income is business income, the whole income could become taxable in the trustee's hands at MMR. That is why Category III funds, which trade actively and use derivatives, worry so much about how their gains are characterised.
Section 224 is a toll plaza with a FASTag lane only for two kinds of vehicles
At a toll plaza, cars with FASTag glide through while trucks stop and pay. Section 224 is the FASTag lane - non-business income passes straight through to investors and is taxed in their hands. But the lane is only open to Category I and II AIFs. A Category III fund must stop at the booth and follow the general trust rules.
Key terms in this chapter
- Alternate Minimum Tax (AMT)
- A tax on non-corporate taxpayers at 18.5 per cent (15 per cent for co-operative societies) of adjusted total income where it exceeds tax under normal provisions.
- BEPS
- Base Erosion and Profit Shifting - the tax avoidance strategies targeted by the OECD's 15 Action Plans developed in 2015 under a G20 mandate.
- Bonus stripping
- Buying securities or units within 3 months before the record date, receiving bonus units, and selling the originals within 9 months after. The loss is ignored and treated as cost of the bonus units. Since 1 April 2022 it covers AIF units too.
- Capital asset (Finance Act 2025 amendment)
- Section 2(22) was amended to include securities held by SEBI or IFSCA registered Category I and II AIFs, so their gains are capital gains, not business income, from April 1, 2025.
- Carry forward of losses
- Unadjusted business loss can be carried forward for 8 tax years against business income, speculative loss for 4 years, and capital loss for 8 years against capital gains.
- Deemed income under section 92(2)(m)
- Where property, including shares and securities, is received for a consideration lower than fair market value by more than ₹50,000, the whole difference is taxed as income from other sources.
- Determinate trust
- A trust whose beneficiaries are identifiable, and whose individual shares of income are ascertainable, on the date of the trust deed. Its trustee is taxed as Representative Assessee under section 304.
- GAAR
- General Anti-Avoidance Rules, effective from 1 April 2017, letting tax authorities disregard or re-characterise an arrangement whose main purpose is a tax benefit and which has one of four tainted elements.
- Impermissible avoidance arrangement
- An arrangement whose main purpose is a tax benefit and which creates non-arm's-length rights, misuses the ITA, lacks commercial substance, or is carried out in a way not normally used for bona fide purposes.
- Indeterminate trust
- A trust that does not meet the determinate test. Its trustee could be taxed at the Maximum Marginal Rate under section 307.
- Intra-head and inter-head set-off
- Setting off a loss against income under the same head (section 108) or against another head (section 109). Capital losses cannot be set off against any other head, and business losses cannot be set off against salary.
- Investment Fund (section 224)
- The regime for Category I and II AIFs under which non-business income is exempt in the fund and taxed in investors' hands, while business income is taxed at fund level and exempt for investors.
- Limitation of Benefit (LOB) clause
- A treaty clause restricting treaty benefits to genuine residents. CBDT clarified that GAAR will not be invoked where an LOB clause sufficiently addresses tax avoidance.
- Maximum Marginal Rate (MMR)
- The income-tax rate, including surcharge, applicable to the highest slab of income of an individual, AOP or BOI, as set in the Finance Act of the relevant year.
- Minimum Alternate Tax (MAT)
- A tax on domestic companies at 14 per cent of book profits (plus surcharge and cess) where it exceeds tax under normal provisions. Credit can be carried forward for 15 years.
- Multilateral Instrument (MLI)
- The OECD instrument under BEPS Action Plan 15 that modifies many tax treaties at once. India signed on 7 June 2017, deposited ratification on 25 June 2019, and it entered into force on 1 October 2019.
- Pass-through status
- Treatment under which income of a fund is taxed in the hands of investors instead of the fund. Under the ITA it is given to Category I and II AIFs under section 224, but not to Category III AIFs.
- Representative Assessee
- A person, such as the trustee of a determinate trust, who is assessed and pays tax on behalf of beneficiaries, in the same manner and to the same extent as it would be levied on them.
- Revocable transfer
- A transfer where the document lets the transferor get back the income or asset, or reassume power over it. Income from it is taxed in the hands of the transferor under sections 97 and 98.
- Securities Transaction Tax (STT)
- A tax on transactions on a recognised stock exchange, such as 0.1 per cent on each side of delivery-based equity trades and 0.05 per cent on sale of futures.
- Short-term capital asset
- A listed security held 12 months or less, or an unlisted security held 24 months or less. Some assets are always short-term: MLDs and specified mutual funds from 01-04-2023, and unlisted bonds and debentures from 23-07-2024.
- Stamp duty on AIF units
- From 1 July 2020, 0.005 per cent on issue and 0.015 per cent on transfer of AIF units, paid by the fund on behalf of investors. No stamp duty applies on redemption.
- Tax Residency Certificate (TRC)
- A certificate from the foreign tax authority that a non-resident needs to claim treaty benefits in India, filed with Form 41.
- Tax year
- The 12-month period of the financial year beginning on 1 April. For a newly set-up business or profession, it runs from the date of setting up to the end of that financial year.
- Withholding tax
- A sum deducted from income when it is paid or credited. An Investment Fund deducts 10 per cent on non-business income to residents and 20 per cent on dividends to non-residents.
Check you have understood it
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Create a free accountOriginal explanatory writing based on the official NISM workbook for Series XIX-E, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.