Tax pass-through for AIFs: getting it right at the GP level

Pass-through tax treatment under Section 115UB of the Income Tax Act is the structural reason most Indian AIFs choose Cat I or Cat II over Cat III. The fund is not taxed at the entity level; income passes through to the unit-holders and is taxed in their hands at their applicable rates. The headline is clear and the mechanics for LPs are well documented.

The GP-level taxation is less well understood and is where first-time GPs leak meaningful money. The management fee is taxed as ordinary business income, not as pass-through. The carry's tax treatment depends on its characterisation. The GST on the management fee is a real cash cost. Each of these has structural implications for how the GP organises its operations.

This article walks through the LP-level pass-through (briefly), the GP-level traps (in detail), and the recent CBDT clarifications that shape the current position.

The LP-level pass-through, briefly

Section 115UB treats Cat I and Cat II AIFs as tax-transparent. The fund's income (capital gains, business income, interest, dividends) passes through to the unit-holders in proportion to their holdings. The unit-holders are taxed at their applicable rates for each character of income.

Operational mechanics:

1. The fund earns income at the fund level.

2. The character of the income (long-term capital gain, short-term capital gain, business income, interest, dividend) is preserved.

3. The fund distributes the income to LPs in proportion to their unit holdings.

4. The fund withholds tax at the rate specified under Section 194LBB (10% for resident LPs, with higher rates for specific situations).

5. The LP claims credit for the withheld tax in their personal tax return.

Cat III AIFs do not get pass-through. Cat III is taxed as a business entity at the fund level, and distributions to LPs are typically treated as a return of capital (subject to specific structuring).

The GP-level trap 1: Management fee is business income

The management fee that the fund pays to the GP entity is the GP's revenue. It is taxed as business income at the GP entity's applicable rate.

For a GP organised as an LLP, the LLP is taxed at 30% plus surcharge plus cess (effective rate around 35-37%). The LLP partners then receive their share of profits as exempt income under Section 10(2A).

For a GP organised as a private limited company, the company is taxed at 25% (under the 25% concessional rate for new companies, or 22% if the company has opted into the 22% rate under Section 115BAA). The shareholders then receive dividends, which are taxed at their personal rate (typically 30%+ for the founding partners). The total tax leakage is higher under the company structure (22% at company level + 30% at shareholder level on dividends = effective rate around 45%+).

For a GP organised as a partnership firm, similar to LLP treatment.

The implication: the GP entity structure choice affects the effective tax rate on management fee income by 5-10 percentage points. LLP is typically the most efficient structure for the GP entity. We see this confirmed in most fund formation work.

The GP-level trap 2: Carry characterisation

Carried interest is the GP's 20% share of fund profits after the hurdle. The tax characterisation of carry has been the subject of significant interpretation and CBDT clarification over the last few years.

The historical position. Carry was widely treated as the GP's share of capital gains, preserving the character of the underlying fund income. For long-term capital gains, this meant the GP paid 10% LTCG tax on its carry from equity exits.

The challenged position. The tax department took the view in several cases that carry is compensation for services rendered (the GP's investment management services), not a return on investment, and should be taxed as ordinary business income.

The current position (2024 CBDT clarification). The CBDT clarified that carry on funds where the GP has made a sponsor commitment proportional to the fund corpus (the 2.5% or ₹5 crore for Cat I/II) can be treated as preserving the character of the underlying fund income, subject to specific conditions. Carry on funds where the GP has not made a sponsor commitment, or where the sponsor commitment is debt-funded, is more likely to be treated as business income.

The operational implication: GPs that fund their sponsor commitment from their own balance sheet preserve the favourable carry treatment. GPs that fund the sponsor commitment from a side arrangement with an anchor LP, or through bank borrowing, face higher tax risk on carry.

The GP-level trap 3: GST on management fee

Management fee is a service. The supply of services attracts GST.

For Cat I and Cat II AIFs, the management fee is subject to GST at 18% (under the 'Other professional, technical and business services' classification). For Cat III AIFs, depending on the structure, the GST rate may be 18% or 12%.

The GST is collected by the GP from the fund and remitted to the tax authority. The fund cannot typically claim input tax credit on the GST (because the fund's outputs are mostly capital gains, which are exempt from GST). The GST is therefore a real cash cost that reduces the fund's net IRR.

On a ₹500 crore fund with 2% management fee, the annual management fee is ₹10 crore. The GST on that is ₹1.8 crore per year, or ₹18 crore over ten years. That is approximately 36 basis points per year on fund corpus, which is a meaningful drag.

The mitigation: structure the GP and the fund such that the GP can claim some input tax credit, or such that the management fee is structured with a partial credit recovery. The mitigation depends on the GP entity structure and the specific services being provided.

The GP-level trap 4: Carry timing and the 2025 amendment

The 2025 SEBI amendment did not directly change the tax treatment of carry but did change the operational mechanics in a way that has tax implications. The expanded LP reporting requirements and the more transparent waterfall disclosure mean that the timing of carry recognition is more clearly documented.

Carry is recognised for tax purposes when it accrues to the GP. With clearer documentation of when carry has been earned (versus when it is paid), the tax authorities have more visibility on the accrual point. GPs that previously could time the recognition of carry to specific tax years now have less flexibility.

The CBDT has indicated through informal guidance that it is monitoring the carry recognition question more closely in 2026. We expect a formal circular within the next twelve months clarifying the position.

The state-level GST overlay

The GST on management fee is structured as Central GST + State GST (each at 9% under the 18% headline rate). The state-level GST depends on the place of supply rules. For an AIF where the GP and the fund are in different states, the place of supply is typically the recipient's location (the fund's location).

This creates an operational question for GPs with multi-state operations: where is the GP entity registered, where is the fund's registered office, and how does the GST flow between the two states. The administrative cost of managing multi-state GST is meaningful for smaller GPs.

What 2026 may change

Three threads to watch in the 2026 tax landscape:

Carry characterisation. The CBDT is likely to issue formal guidance on carry taxation. The expected direction is to confirm the current position (carry preserves character if sponsor commitment is genuine) with tighter documentation requirements.

GST on management fee. Industry advocacy is pushing for a reduced GST rate on AIF management fees (similar to mutual funds, which enjoy lower GST). The outcome is uncertain but a reduction from 18% to 12% would meaningfully reduce the GP's tax drag.

LP-level tax simplification. The expanded LP reporting under the 2025 amendment is creating pressure for LP-level tax simplification. The proposal under discussion: a single composite tax certificate from the fund covering all LP-level tax characterisation, replacing the current multi-document approach.

One headline benefit, four GP-level traps

Pass-through is the structural benefit that makes Indian AIFs operationally efficient for LPs. The benefit does not extend to the GP, where management fee is ordinary business income, carry characterisation depends on structuring, GST is a cash cost, and timing matters for tax efficiency. First-time GPs that organise the GP entity, the sponsor commitment, and the management fee structure with the GP-level tax position in mind save meaningful money. GPs that focus only on the LP-level pass-through and ignore the GP-level tax leakage often discover at year three or four that the GP economics they planned for are not the GP economics they are getting.