Corporate amendment bill likely to provide tax relief to Category III AIFs

The amendments, introduced in Parliament and now before a Joint Parliamentary Committee, would for the first time allow specified trusts regulated by the Securities and Exchange Board of India (Sebi) to convert into LLPs.

AIFs invest in alternative assets such as private equity, hedge funds and other non-traditional investments beyond traditional stocks and bonds, with wealthy individuals and institutions as their main investors. There are three categories of AIFs in the country, with Category III AIFs focusing on high-risk, high-return trading strategies using leverage.

Category III AIFs do not enjoy tax pass-through status and are taxed at the fund level, which means that these funds pay tax before distributing proceeds to investors. The tax burden can be as high as 39%, compared with Category I and II AIFs, where long-term capital gains (LTCG) are taxed at 12.5% and short-term gains at 20%.

“It is pertinent to note that even a determinate trust may attract the maximum marginal rate on business income, whereas an LLP is assessed at a rate of 30%, representing a rate advantage for funds with significant business income,” said S.R. Patnaik, partner (head - taxation) at Cyril Amarchand Mangaldas. The effective tax rate for an LLP is 35%.

The high taxation stems from a 2014 circular by the Central Board of Direct Taxes (CBDT). It said that if a trust deed did not identify beneficiaries and their beneficial interests, the trust could be treated as indeterminate and taxed at the maximum marginal rate (MMR). A determinate trust would specify its investors at the time of incorporation.

Category III AIFs raised commitments worth ₹3.15 trillion as of March, 2026, according to Sebi.

Where the high tax comes from

The circular further stated that even determinate trusts earning business income would continue to be taxed at the maximum marginal rate. The clarification created a structural problem because AIFs may not be able to determine all beneficiaries at inception.

MMR is the highest tax rate that applies to a taxpayer's last rupee of income earned. For fiscal year 2026 (FY26) under the new tax regime, the maximum marginal tax rate can reach 39% (30% base tax + 25% surcharge + 4% cess) for income exceeding ₹2 crore, representing the highest effective tax burden on the top slab.

The move from MMR to LLP taxation could lead to an arbitrage of over 3-5%, said experts.

Sameer Gupta, national tax leader at EY India, said Category III AIFs pursuing long-short strategies had historically preferred LLPs where possible because of the lower tax incidence and greater certainty.

“An LLP also has more certainty in taxation relative to a trust, which has several aspects that could lead to tax risks to the fund and its investors, given that the framework for trust taxation was never designed to apply to investment funds,” he said.

The Bill seeks to solve the legal bottleneck by creating a dedicated framework for the conversion of Sebi-regulated trusts into LLPs.

To be sure, AIFs can choose to incorporate as LLPs even now. However, many have opted against this route because most AIFs in India are structured as trusts, a model that is generally considered more investor-friendly. Moreover, investors value confidentiality, which could be compromised under the LLP structure, where partners' identities must be publicly disclosed.

The move to LLP for lower taxation comes at the cost of investor confidentiality.

Confidentiality trade-off…

"Category III funds are the most excited to change to an LLP," an AIF executive said, on the condition of anonymity. He added that some Category I and II funds backed by foreign limited partners also see merit in the flexibility offered by LLP structures.

Industry participants also do not expect a wholesale migration.

Another AIF official said granting Category III AIFs pass-through taxation or reducing MMR to 30% for such funds would be a better proposition, as making all partner information public may not be desirable for several AIFs.

Sumeet Hemkar, partner, Deloitte India, said fund managers would weigh whether conversion is tax-neutral, the treatment of carried interest and investor distributions, operational issues around the admission and exit of investors, investor preferences, and transition costs before changing structures.

"If transition costs outweigh the benefits, existing large funds may continue with the trust structure. Consequently, we may witness selective migration rather than an industry-wide shift," he said.

…and carry still unresolved

Yet while the Bill addresses one long-standing structural issue, it remains silent on what many fund managers consider the bigger unresolved tax problem: carried interest.

Carry, the share of investment profits earned by fund managers as a performance incentive, has for years existed in a legal grey area because neither the Income-tax Act nor the goods and services tax (GST) law explicitly defines its tax treatment. That ambiguity has fuelled concerns that tax authorities could recharacterize carry as consideration for services rather than investment income.

The industry had hoped that the bill would provide clarity on the issue. Instead, the Bill focuses only on enabling conversion to LLPs and does not prescribe how carried interest should be taxed.

“Category I and Category II AIFs set up as LLPs should continue to remain eligible to take advantage of the tax pass-through status accorded to such AIFs under the Income-tax Act, 2025, irrespective of these amendments. There is no separate tax recognition given to carried interest; it is a commercial construct which is not intended to interfere with the tax pass-through structure of such AIFs,” said Nandini Pathak, partner, Bombay Law Chambers.

The first AIF executive mentioned above said the industry has repeatedly asked the government to clarify taxation on carry but has yet to receive a response. "The conversion of AIFs to LLPs was initially expected to bring in some clarification, but that doesn't seem to be the case," the person said.