Deemed credit rule

A Category I or II Alternative Investment Fund passes most of its income straight through to its investors, who are taxed on it as if they had earned it directly. But what if the fund earns income during the year and simply has not paid it out by the time the year closes?

The Act does not let that timing gap defer the tax. Under the deemed credit rule, income the AIF has earned but not actually paid or credited to an investor by year-end is treated as if it had been credited — on the last day of the previous year — in the same proportion the investor would have received had it actually been paid out.

This is part of the pass-through mechanism for Category I and Category II AIFs under Section 115UB. Two limbs work together:

1. Income actually paid or credited during the year is taxed in the investor's hands as if it had accrued to them directly, retaining its original character (business income, capital gains, or other income).
2. Income accruing to the AIF but not paid or credited by year-end is deemed to have been credited to each investor's account on the last day of the previous year, in the proportion that investor was entitled to.

The exception: income taxable as business income at the AIF level itself (taxed there at company/firm rates, or at the maximum marginal rate if the AIF is a trust or other body) is not passed through, deemed or otherwise — that piece stays taxed at the fund level and is exempt in the investor's hands under Section 10(23FBB).

The workbook's Example 14. A Category-I AIF, registered as a trust, earns business income of Rs 20 lakh, capital gains of Rs 15 lakh, and income from other sources of Rs 5 lakh in a year. Mr X holds 30% of its units. During the year, the AIF has credited the entire income to investors except the income from other sources.

At the AIF level: the Rs 20 lakh business income is taxed at the maximum marginal rate, since pass-through does not apply to it and the AIF is a trust.

In Mr X's hands:

Income under PGBP (exempt u/s 10(23FBB))            —
Income under capital gains, actually credited      Rs 4,50,000   (30% x 15 lakh)
Income from other sources, DEEMED credited          Rs 1,50,000   (30% x 5 lakh)
Total income in Mr X's hands                         Rs 6,00,000

The Rs 1,50,000 is taxable to Mr X even though the AIF never actually paid it out during the year — the deemed credit rule brings it into his income on the last day of the year regardless.

Chapter 12 (Taxation of Other Products), section 12.6, on taxation of Category-I and Category-II AIFs under Section 115UB, sets out the deemed credit rule and works Example 14 in full. Expect a question with an AIF that has not distributed all its income, asking what an investor must still include as taxable income.

• Not distributing income does not defer tax for the investor — that is precisely what the deemed credit rule closes off.
• Business income of the AIF is the one carve-out — it is taxed at the fund level and exempt to the investor, unlike other income categories, which pass through (actually or by deemed credit) and are taxed to the investor.
• The deemed credit date is the last day of the previous year, not the date the income is eventually actually paid.
• This applies only to Category I and Category II AIFs — Category III AIFs are taxed like an ordinary trust, company or LLP, with no pass-through at all.