NISM Series XIX-D · Chapter 13: Taxation

L1 · Foundation

The Pass-Through Principle - How an AIF Is Taxed

The basis of charge for residents and non-residents, what an "Investment Fund" means under Section 224, how tax pass-through works for non-business income, why business income is taxed at fund level instead, the Finance Act 2025 fix on capital gains, and the five rules governing income in a unitholder's hands.

26 min read · Worth 5% of the paper · Written from pages 306–328 of the official NISM workbook · Updated 17 September 2026

The Pass-Through Principle

The basis of charge

Under the Income Tax Act, the basis of charge depends on two things: the residential status of the taxpayer during a tax year, and the nature of the income earned.

Status	What India taxes
Resident in India (natural or juridical person)	Worldwide income, subject to certain tax exemptions and deductions
Non-resident for Indian tax purposes	Generally only Indian-sourced income, or income accrued, received or deemed to be accrued or received in India

"Tax year" means the 12-month period of the financial year commencing on 1 April. For a newly set up business or profession, the tax year runs from the date of setting up to the end of that financial year.

13.1.1 How the AIF itself is taxed

The vehicle: AIFs can be in the form of a trust, a limited liability partnership, a company or a body corporate. But the majority of AIFs are constituted as a CONTRIBUTORY, DETERMINATE, IRREVOCABLE TRUST under the Indian Trusts Act, 1882.

Those three words matter and they recur in exams. Contributory - investors contribute. Determinate - the beneficiaries and their shares are identified, which is what allows the income to be attributed to them. Irrevocable - the settlor cannot take the property back, which prevents the income being taxed back in his hands.

AIFs must be registered with SEBI under the AIF Regulations, or migrated from the erstwhile Venture Capital Regulations.

The definition of "Investment Fund" - Section 224

"Investment Fund" means 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, made under the SEBI Act, 1992, or regulated under the International Financial Services Centres Authority (Fund Management) Regulations, 2022 made under the IFSCA Act, 2019.

Two things follow. Only Category I and Category II AIFs get the status. And the definition expressly extends to funds regulated by IFSCA, which is how GIFT City funds come within it.

The governing sections: the taxability of Category I and II AIFs is governed by Section 11 (Schedule V - Table Sl. No. 1 and 2), 224, 393(1)(4-iii), 393(2)(8) and 402(42) of the ITA.

What "tax pass through" actually 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.

The mechanism in the statute: 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 last phrase is the whole doctrine. The fund is treated as a conduit, not as an owner. A pension fund investor pays what a pension fund would pay; an individual pays what an individual would pay; a non-resident pays what a non-resident would pay - on the same underlying income.

Business income is the exception

Business income accruing or arising to, or received by, an Investment Fund is taxable AT THE FUND LEVEL at:

If the fund is	Rate
A company or firm	The specified rate in the Finance Act of the relevant year
In other cases	The Maximum Marginal Rate (MMR)

And having been taxed at the fund, such business income is EXEMPT in the hands of the investors.

MMR defined: 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 body of individuals, as specified in the Finance Act of the relevant year.

Note what this does. Business income is taxed at the highest rate irrespective of who the investors are - a small investor gets no benefit from his own lower slab. That is why the characterisation question below mattered so much.

Losses - the asymmetry

Type of loss	Treatment
Business loss at fund level	NOT allowed to be passed through to investors. It is permitted to be carried forward for set-off against business income of subsequent years in accordance with the ITA
Loss other than business loss	Allowed to be passed through to the investors, and carried forward and set off in their hands - but only where the investors have held the units of the AIF for at least 12 MONTHS

The 12-month holding condition is a specific, examinable requirement. An investor who bought units nine months ago cannot take the fund's capital loss.

Characterisation - capital gains or business income?

The problem. Whether securities are held as capital assets or as stock-in-trade is a mixed question of law and fact, depending on the facts and circumstances of each case, and upon whether the activities of the Fund could be regarded as amounting to the carrying on of a business or profession.

Why it mattered so much. There was a longstanding controversy on whether gains on the sale or transfer of securities by Category I and Category II AIFs are taxable as business income of the fund, or as capital gains accruing in the hands of the underlying investors.

Follow the consequences of each answer:

If treated as	Taxed where	At what rate	Investor's position
Business income	At the fund	MMR (for a trust)	Exempt in his hands, but he bore the highest rate indirectly
Capital gains	In the investor's hands	His own applicable capital gains rate	Pass-through works as intended

The Finance Act 2025 fix

The Finance Act 2025 removed the ambiguity. Section 2(22), 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 or IFSC Authority registered Category I and II AIFs.

The consequence: 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 1 April 2025.

And the scope is wide: since the word "securities" is widely defined under law - under Section 2(h) of the Securities Contracts (Regulation) Act, 1956 - 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 development in the chapter. It converts the pass-through from a principle subject to argument into one that works in practice for the ordinary activity of a Category I or II AIF.

13.1.2 Income in the hands of resident investors - the five rules

The ITA provides that non-business income of an Investment Fund is exempt in the fund's hands and chargeable directly in the hands of the unitholders, governed by five rules:

(a) Same manner as a direct investment. 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) Same nature and same proportion. The income paid to the Unitholders by the Fund, or credited to their account, 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 accrued or arisen to, the Fund.

So interest stays interest, dividend stays dividend, and a long-term capital gain stays a long-term capital gain. The fund cannot change the character of income by passing it through.

(c) Deemed credit at year end. Income accrued or 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, in the same proportion as they would have been entitled to receive it had it been paid in that year.

This is the rule investors find hardest to accept. Tax can fall due on income the investor has not yet received in cash. An AIF that earns interest in March and distributes it in the following August has still credited that income to the investor for the earlier year.

(d) No double inclusion. Once the income is included in the total income of the Unitholder in a tax year on account of having accrued or arisen in that year, it shall NOT be included again in the year in which such sum is actually paid to him by the Fund.

Rule (d) is the necessary companion to rule (c). Tax is paid once, at accrual.

(e) Pass-through of losses, with a condition. 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 while computing their income. 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.

The three streams of income

The AIF generally earns income of the following nature from its portfolio investments - investments in debt securities, equity instruments and so on:

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

The next lesson works through how each is taxed in the hands of the unitholder, for residents and non-residents.

13.1.3 Non-resident investors - the basic position

A non-resident investor would be subject to taxation in India only if it derives:

(a) Indian-sourced income; or (b) any income received or deemed to be received in India; or (c) any income accrued or deemed to have accrued in India in terms of the provisions of the ITA.

And for non-business income of the fund, the pass-through rules apply identically: the above provisions apply both to resident and non-resident investors in the same manner.

What differs for a non-resident is not the pass-through mechanism but the rates, and the availability of treaty relief - both covered in the next lesson.

Think of it like this

Pass-through is the housing society that collects and forwards the water bill

The society collects from every flat and pays the municipal corporation, but the society itself owes nothing - each flat bears its own share. A Category I or II AIF works the same way for non-business income: it is exempt at fund level, and the income is chargeable directly in the investors' hands as if the investments had been made by them directly. The fund is a conduit, not an owner.

Same nature, same proportion is the sealed tiffin passed on

If a neighbour asks you to carry a tiffin of dal to her son, you hand over dal - not rice, and not a smaller portion. Rule (b) says exactly this: income paid or credited to unitholders is deemed to be of the same nature and in the same proportion as it was received by the fund. Interest stays interest and a long-term capital gain stays a long-term capital gain; the fund cannot change what it is by carrying it.

Deemed credit at year end is the salary slip for the month you were not paid

An employer who defers your March salary to June still shows it in your Form 16 for the earlier year, and you pay tax on it then. An AIF works the same way: income accrued to the fund but not credited or distributed is deemed to have been credited to the unitholders at the end of that financial year. Cash and tax do not always arrive together, and the investor must be told so before he commits.

Business income at MMR is the shared taxi charged at the fastest passenger's fare

Imagine a shared taxi where everyone is billed at whatever the wealthiest passenger would have paid. That is what happens to an AIF's business income: it is taxed at the fund at the maximum marginal rate - the rate for the highest slab - regardless of which investors actually own the fund. A small investor gets no benefit from his own lower slab, which is precisely why the capital-gains characterisation mattered so much.

The Finance Act 2025 fix settled which counter you stand at

For years a fund selling a portfolio company did not know whether to queue at the business-income counter or the capital-gains counter, and the answer changed the tax bill for everyone behind it. The Finance Act 2025 amended the definition of capital asset to specifically include securities dealt with by registered Category I and II AIFs - so from 1 April 2025 there is one queue, and it is the capital gains queue.

Determinate and irrevocable is the will that names the heirs

A will that says "divide among my children in these exact shares" is very different from one that says "the trustee may decide someday". Only the first lets the tax authorities attribute income to identified beneficiaries. That is why most Indian AIFs are constituted as contributory, determinate, irrevocable trusts - determinate so the shares are known, irrevocable so the settlor cannot pull the property back and have the income taxed in his own hands.

The 12-month holding for losses is the membership card before the discount

A club gives members a discount, but only after a year of membership - you cannot join in the morning and claim it at lunch. Non-business losses at fund level pass through to unitholders, but only where the unitholder has held the units for at least twelve months. An investor who bought nine months ago carries none of the fund's loss.

Business loss stuck at the fund is the shop loss that cannot go on your salary slip

A man who runs a loss-making side business cannot set it against his salary in the same way he can adjust other losses; it stays with the business and waits for future business profit. An AIF's business loss behaves the same way - it is not passed through to investors at all, and is only carried forward at fund level for set-off against business income of later years.

Key terms in this chapter

Alternate Minimum Tax (AMT): Levied on non-corporate assessees at 18.5 per cent, or 15 per cent for a co-operative society, plus surcharge and cess, on adjusted total income where that exceeds tax under the normal provisions, except where the options under sections 202, 203 or 204 are exercised.
Basis of charge: Tax liability depends on the residential status of the taxpayer during a tax year and the nature of income earned. A resident is liable on worldwide income; a non-resident only on Indian-sourced income or income accrued, received or deemed to be accrued or received in India.
Bonus stripping: Where units are bought within three months before a bonus record date, additional units are received free, and the original units are sold within nine months after the record date while the additional units are retained, the resulting loss is ignored and instead deemed to be the cost of acquisition of the additional units held.
Business loss at fund level: Not allowed to be passed through to investors; it may only be carried forward at fund level for set-off against business income of subsequent years.
Carry forward of capital loss (Section 111): Unadjusted capital loss may be carried forward for eight years immediately succeeding the year of loss, and in later years may be set off only against capital gains - long-term loss only against long-term gains, short-term loss against either.
Characterisation controversy: The longstanding question whether gains on sale or transfer of securities by Category I and II AIFs were business income of the fund or capital gains in investors' hands - the difference between taxation at MMR at the fund and concessional capital gains rates for investors.
Contributory, determinate, irrevocable trust: The structure in which the majority of Indian AIFs are constituted under the Indian Trusts Act, 1882 - contributory because investors contribute, determinate because beneficiaries and their shares are identified, and irrevocable because the settlor cannot take the property back.
Conversion is not a transfer: Conversion of preference shares or of convertible debentures of a company into equity shares of that company is not regarded as a transfer, so no capital gains arise; the cost of the converted instrument is deemed the cost of the equity shares, and the pre-conversion holding period is included.
Deemed credit at year end: Income accrued or received by the fund in a financial year which has not been credited or distributed to unitholders is deemed to have been credited to their accounts at the end of that year, in the proportion in which they would have been entitled to receive it - so tax can fall due on cash not yet received.
Deemed income on property below FMV: Under Section 92(2)(m), where a person receives property including securities at a price lower than fair market value, the difference is taxable in the recipient's hands if it exceeds Rs 50,000, at his applicable slab rates.
Deemed sale consideration (Section 79): Where unquoted shares are transferred at a value lower than fair market value, the FMV is deemed to be the full value of consideration for computing capital gains. FMV of unlisted equity shares is based on book values; for other shares and securities it is market value certified by a merchant banker or chartered accountant.
Deemed short-term assets: Three categories are deemed short-term irrespective of holding period: Market Linked Debentures transferred, redeemed or matured on or after 01-04-2023; Specified Mutual Funds acquired on or after 01-04-2023; and unlisted bonds or debentures transferred, redeemed or matured on or after 23-07-2024.
Dividend taxation: The Indian company pays no dividend distribution tax; the dividend is taxable in the shareholder's hands. No deduction for expenses is allowed under section 93, and for a non-resident it is taxed on a gross basis under Sections 207 to 210.
Extended bonus stripping scope: Effective 1 April 2022, the bonus stripping provisions cover all securities and units, including units of a business trust such as a REIT or InvIT and the beneficial interest of an investor in a SEBI-registered AIF.
Finance Act 2025 capital asset amendment: Section 2(22), defining "capital asset", was amended to specifically include securities dealt with by SEBI or IFSC Authority registered Category I and II AIFs, so that from the financial year beginning 1 April 2025 income from their transfer is taxed as capital gains and not business income.
Form No. 78: The statement of income paid or credited by an Investment Fund to a unit holder in a tax year, furnished to the unit holder by the 30th day of June of the following tax year, duly verified by the person paying or crediting the income on behalf of the fund.
Form No. 79: The corresponding statement furnished electronically by the Investment Fund to the jurisdictional Principal Commissioner or Commissioner of Income Tax by the 15th day of June of the following tax year, under digital signature and duly verified by a practising Chartered Accountant.
GAAR clarifications: GAAR shall not be invoked where tax avoidance is sufficiently addressed by a Limitation of Benefit clause in a treaty, nor merely on the ground that an entity is located in a tax-efficient jurisdiction; and GAAR applies to an arrangement or part of it, with the Rs 30 million limit not read in respect of a single taxpayer only.
GAAR test: An arrangement is an impermissible avoidance arrangement if its main purpose is to obtain a tax benefit and it satisfies one of four tainted elements - non-arm's-length rights or obligations, misuse or abuse of the ITA, lack of commercial substance, or being carried out in a manner not normally employed for bona fide purposes.
GST on fund services: GST at 18 per cent is levied on investment management fees and trusteeship fees payable by the Fund to the Investment Manager and the Trustee respectively.
Holding period for listed securities: More than twelve months makes a listed security, unit of UTI, unit of an equity-oriented fund or zero coupon bond a long-term capital asset; twelve months or less makes it short-term.
Holding period for unlisted securities: More than twenty-four months makes an unlisted security - including those offered through an offer for sale in an IPO - a long-term capital asset; twenty-four months or less makes it short-term.
Interest income taxation: Taxable under the head Income from Other Sources at ordinary rates for residents; for non-residents on a net basis at ordinary non-resident rates, though certain specified interest income of a non-resident or foreign company is chargeable on a gross basis at special rates.
Inter-head adjustment (Section 109): Loss under one head may be adjusted against income under another, but only after intra-head adjustment is made; loss under the head Capital gains cannot be set off against any other head, and business loss cannot be set off against Salaries.
Intra-head adjustment (Section 108): Loss from one source may be adjusted against income from another source under the same head, subject to restrictions - long-term capital loss only against long-term capital gains, short-term capital loss against long-term or short-term gains, and speculative losses only against speculative gains.
Investment Fund (Section 224): Any fund established or incorporated in India as a trust, company, LLP or body corporate which holds a certificate of registration as a Category I or Category II AIF under the SEBI (AIF) Regulations, 2012, or is regulated under the IFSCA (Fund Management) Regulations, 2022.
Maximum Marginal Rate (MMR): The rate of income-tax, including surcharge if any, applicable in relation to the highest slab of income in the case of an individual, association of persons or body of individuals, as specified in the Finance Act of the relevant year. It is the rate at which an AIF trust's business income is taxed at fund level.
Minimum Alternate Tax (MAT): Levied on domestic companies at 14 per cent of book profits, plus surcharge and cess, where that exceeds tax under the normal provisions - except for life insurance companies and certain others exercising the option under Section 200(5) or 201(2). Credit may be carried forward for fifteen years.
Multilateral Instrument (MLI): The instrument envisaged by Action Plan 15 of the OECD BEPS project to modify the global tax treaty network in a synchronised manner. India signed it on 7 June 2017 covering 93 treaties, deposited its ratification on 25 June 2019, and notified entry into force from 1 October 2019.
No double inclusion rule: Once income has been included in a unitholder's total income in the year it accrued, it is not included again in the year the sum is actually paid to him by the fund.
No withholding by portfolio companies: The payer of income to an Investment Fund is not required to withhold tax while paying or crediting income other than business income, so the fund suffers no withholding on its non-business income - tax is instead deducted downstream on distribution to investors.
Pass-through of non-business losses: Losses other than business losses are passed through to unitholders for set-off or carry forward in their hands, but only where the unitholder has held the units of the AIF for at least twelve months.
Rs 1,25,000 LTCG threshold: No tax is payable on long-term capital gains from equity shares on which STT has been paid on both acquisition and transfer, where the total such gains in a financial year do not exceed Rs 1,25,000; the excess is taxed at 12.5 per cent without indexation.
Same nature and same proportion rule: Income paid or credited to unitholders is deemed to be of the same nature and in the same proportion in their hands as it was received by or accrued to the fund - so interest stays interest and a long-term capital gain stays a long-term capital gain.
Section 159 more-beneficial rule: The provisions of the ITA apply to the extent they are more beneficial than the provisions of the applicable tax treaty, subject to GAAR and to the Multilateral Instrument - so the taxpayer receives the better of the two, not a free choice.
Securities (definition adopted): Widely defined under Section 2(h) of the Securities Contracts (Regulation) Act, 1956, covering all types of equity and debt securities, listed and unlisted, that Category I and II AIFs deal with.
Share of LLP profits: A partner's share in the total income of an LLP or partnership firm is exempt in his hands subject to conditions, and accordingly such share of profits on a pass-through basis is exempt in the hands of the AIF's unitholders.
Stamp duty on AIF units: With effect from 1 July 2020, issue of AIF units attracts 0.005 per cent and transfer attracts 0.015 per cent, paid by the Fund on behalf of the investors at the time of issuance or transfer. No stamp duty is payable on redemption.
STT negative list: The three situations in which the relaxation from the STT-on-acquisition condition does not apply - preferential issues of infrequently traded listed shares other than specified preferential issues, acquisitions not through a recognised stock exchange except in specified circumstances, and acquisitions during a delisting-to-relisting period.
Tax pass through: Zero tax liability on income other than business income at Investment Fund level, with that income taxable directly in the hands of the investors as per their respective tax status - in the same manner as if the investments had been made directly by them.
Tax Residency Certificate (TRC): The certificate issued by a foreign tax authority that a non-resident must obtain to claim treaty benefits, furnished with such other prescribed information or documents and with Form 41 filed electronically.
Tax treaty shopping: Arrangements aimed at obtaining reliefs provided in a double taxation avoidance agreement for the indirect benefit of residents of another country - which section 159 requires India's treaties to avoid creating opportunities for.
Tax year: The twelve-month period of the financial year commencing 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.
Transfer of AIF units: Units of an AIF are long-term capital assets if held more than twelve months when listed or more than twenty-four months when unlisted, with long-term gains taxed at 12.5 per cent without indexation and short-term gains at applicable slab rates.
Two IPO holding tests: Unlisted shares sold through an offer for sale in an IPO are long-term only if held for more than twenty-four months; unlisted shares acquired and sold after listing on a recognised stock exchange are treated as listed shares and are long-term if held for more than twelve months.
Withdrawal of indexation: The Finance (No. 2) Act, 2024 provided that no indexation benefit is available in respect of long-term capital assets transferred on or after 23 July 2024.
Withholding by an Investment Fund: Under section 393, tax is deducted at 10 per cent on all non-business income distributed to a resident investor; at 20 per cent where a distribution to a non-resident is dividend; and at the rates in force or applicable DTAA rates on other non-resident income. Investors may claim credit in their returns.

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

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