How AIFs are structured and taxed
AIFs fall into three categories under SEBI regulation, and how gains are taxed depends heavily on which category and structure applies.
The three categories
Category I covers funds investing in areas the government considers economically or socially desirable, such as venture capital, SME funds, social impact funds and infrastructure funds. These often carry certain incentives and are not permitted to use leverage beyond specified limits.
Category II includes private equity and private debt funds that do not fall under Category I or III and do not undertake leverage other than for day-to-day operational needs. Most PE and credit-focused AIFs sit in this category.
Category III covers funds that use complex or leveraged trading strategies, including long-short equity funds and funds using derivatives extensively. These typically carry the widest range of risk and return outcomes.
Lock-ins and liquidity
AIFs are close-ended for the most part, especially Category I and II, with typical lock-in periods of three to seven years depending on the fund's stated term. Category III funds are more likely to be open-ended, but even then, exits are usually on specific dates rather than on demand.
How taxation generally works
Category I and II AIFs are typically granted "pass-through" status, meaning the fund itself does not pay tax on most income; instead, gains and income are taxed in the hands of the investor, in the same character as they arose (as capital gains, business income or other income) at the applicable rate. Category III funds are generally taxed at the fund level itself, which changes how post-tax returns reach you. Rules and rates can change, and your own tax outcome depends on your income slab and the specific fund structure, so we always recommend confirming details with your tax advisor before investing.
What to check before investing
- The fund's Private Placement Memorandum (PPM), which sets out strategy, fees, lock-in and exit terms.
- The fund manager's track record on comparable strategies, not just overall AUM.
- Whether the fund is Category I, II or III, since this affects both risk and tax treatment.
- Total costs, including management fee, performance fee (carry) and any other charges.
Who tends to consider AIFs
Given the ₹1 crore minimum and multi-year lock-in, AIFs generally suit investors who have already built a diversified base of more liquid holdings and are looking to add exposure that listed markets do not offer, with capital they will not need to access for several years.