Category III AIFs: Tax Grey Zone and Industry Demands
Why in the news
Category III Alternative Investment Funds have grown into a major segment, yet their tax treatment remains unclear, hurting investor returns and fund efficiency.
Key problems
| Issue | What happens |
|---|---|
| No pass-through status | Tax is paid by the fund; investors are taxed on the fund’s holding period, losing lower LTCG rates |
| Capital gains | Asset sold within a year attracts 20% STCG, even if the investor held units longer; no deferral |
| Derivatives | F&O gains are business income at 39% maximum marginal rate |
| Losses | Fund-level losses cannot be passed on, set off or carried forward by investors |
Trust classification debate
- These AIFs are structured as trusts. A determinate trust (identifiable beneficiaries and shares) is taxed at the beneficiary’s rate.
- An indeterminate trust pays the maximum marginal rate of 39% on all income.
- CBDT (2014) demanded named beneficiaries with fixed shares; AAR 1996, Karnataka HC 2017 and Madras HC 2020 accepted identifiability at any point.
- The industry follows judicial precedent and treats them as determinate trusts, which lacks codified certainty.
Double taxation risk
- Since 2021, AIF units count as securities under the SCRA.
- Gains may be taxed in the fund and again when the investor redeems units.
Way forward
- Pass-through treatment, recognition as determinate trusts and no double taxation.
- Clear use of special rates (12.5% LTCG, 20% STCG).
- A dedicated framework similar to mutual funds, with holding-period-based taxation at investor level.
Exam angle
- Category III AIFs began in 2012; raised over ₹1.29 trillion.
- Regulation reference: SCRA; maximum marginal rate: 39%.