AIF taxation in India (2026): How Cat I/II/III can differ and what to compare

Wednesday, Jan 21, 2026

Investors looking to alternative investment in India no longer take glossy returns charts in 2026. They are posing more incisive questions.

Both Alternative Investment Funds can give a gross return of 20%. However, five years later the amount of post-tax wealth generated on the investor’s side may translate significantly.

Why?

Since the rate of capital compounding depends upon not only investment ability, but also on taxation structure.

With the maturity of the Indian alternative investment market, it is now important to know how taxes are treated with regard to Category I, II, and III AIFs. Taxation can no longer be an indulgence when you are appraising the best alternative investment funds in India, talking with various alternative investment fund managers, and discussing structures that are being offered by various alternative investment partners.

This is an easy-to-follow guide that can be used to simplify the process of AIF taxation in India (2026) and makes you appreciate what is really worth considering before committing capital.

The Future of AIFs in the Contemporary Allocation Landscape

The AIFs are privately diversified funds governed by the Securities and Exchange Board of India (SEBI). They need a minimum investment of 1 crore rupees and are usually targeted at the exposure of experienced investors who are not attracted to other listed stocks.

Over the past years, in this sector, alternative investment management platforms have grown at a high rate. AIFs are becoming increasingly viewed by investors as an element of a structured strategic portfolio, whether they are investing in alternative assets, like in private companies, structured credit, pre-IPO rounds, or niche growth businesses.

Other vehicles such as PMS are in investment portfolios with AIFs. Whereas PMS investing is characterized by direct ownership of listed securities, AIFs are characterized by collective access to differentiated opportunities in both public and private markets.

But what many investors miss is this:

The structure of the AIF determines how and when taxes are paid, and that timing directly impacts compounding.

The Three Categories: Structural Foundations

SEBI classifies AIFs into three categories based on investment mandate and risk profile.

Category I AIF

Category I funds typically invest in sectors that are considered socially or economically desirable, including startups, SMEs, infrastructure, and venture capital opportunities. These funds often support early-stage or growth-oriented businesses and aim for long-term capital formation.

Category II AIF

Category II funds include private equity funds, debt funds, and real estate funds. These are generally closed-ended structures and do not undertake leverage except for limited operational requirements. Many established alternative investment fund managers operate Category II private equity vehicles.

Category III AIF

Category III funds employ diverse or complex strategies, including market-linked approaches and, in some cases, leverage. They can be open-ended or closed-ended. Many dynamic public-market and hybrid strategies fall into this category.

The difference is not merely strategic. It is deeply structural, especially from a taxation standpoint.

The Core Difference: Pass-Through vs Fund-Level Taxation

The most important tax distinction lies here:

Category I and II AIFs generally enjoy pass-through taxation (except for business income). Category III AIFs are taxed at the fund level.

This changes everything.

What Does Pass-Through Mean?

In Category I and II funds, income earned by the fund, whether capital gains, interest, or dividends, is allocated directly to investors. The investor pays tax individually based on the nature of income.

Even if the fund does not distribute the full income in cash, the tax liability may still arise.

This structure places taxation responsibility at the investor level.

What Happens in Category III?

In Category III funds, the tax is paid at the fund level. Investors are not required to pay annual tax on income allocations during the holding period.

Instead, the NAV reflects post-tax performance. Investors experience taxation effectively when they exit or redeem.

This structural shift impacts cash flow, compliance, and compounding.

Tax Structure Comparison (2026)

Parameter	Category I	Category II	Category III
Taxation Model	Pass-through	Pass-through	Taxed at fund level
Tax During Holding	Yes	Yes	No
Who Pays Tax	Investor	Investor	Fund
Impact on Personal Cash Flow	Possible annual outflow	Possible annual outflow	No annual tax outflow
Reporting Complexity	Moderate	Moderate	Relatively simple

 

While pass-through status may seem investor-friendly in theory, the practical implications require careful analysis.

The Compounding Question: Why Timing Matters

Consider an example.

An investor allocates ₹1 crore into a Category II private equity fund. Over five years, the fund generates strong capital gains. However, gains are realized progressively and allocated annually.

Each year, the investor may need to pay tax on allocated income, even if distributions are partially retained for reinvestment.

Those tax payments reduce the investor’s deployable surplus elsewhere.

Now consider the same ₹1 crore invested in a Category III fund delivering identical gross returns. The fund pays tax internally. The investor does not face annual tax outflows. The NAV compounds without personal cash flow interruption.

Over five years, this timing difference can subtly alter wealth accumulation.

Illustrative Post-Tax Comparison

Parameter	Category II (Pass-Through)	Category III (Fund-Level)
Initial Investment	₹1 crore	₹1 crore
Gross Return (Annual)	20%	20%
Annual Investor Tax Liability	Yes	No
Effective Compounding Base	Reduced periodically	Compounds within structure
Administrative Burden	Higher	Lower
Final Outcome	Moderately lower	Potentially more efficient

 

The key takeaway is not that one category is universally superior. It is that structure influences outcomes.

What Sophisticated Investors Should Compare

When evaluating top alternative investment funds in India, investors should move beyond headline IRR.

First, ask how income is expected to be generated. Long-term capital gains? Short-term trading gains? Interest income? Different income types carry different tax consequences.

Second, understand the distribution policy. In pass-through structures, distribution timing and tax liability may not align.

Third, evaluate liquidity. Closed-ended Category II funds may lock capital for longer periods. Category III open-ended structures may provide more flexibility.

Fourth, consider how the AIF integrates into your broader portfolio in strategic management. If you already have equity exposure via PMS, an AIF may add private market diversification.

Some investors evaluating whether to invest in PMS or allocate to AIFs often overlook tax structure differences between these vehicles. While PMS income is taxed directly at the investor level like direct equity investing, AIF structures can behave differently depending on category.

The decision should align with your broader portfolio management strategies, not just short-term return expectations.

Category III and the Rise of Structurally Efficient Allocation

In 2026, many investors gravitating toward alternative investment solutions appreciate the relative simplicity of Category III taxation.

Because taxation is handled at the fund level, reporting complexity reduces. Investors can focus on strategic allocation rather than annual tax compliance arising from pass-through allocations.

This structural efficiency is one reason why Category III vehicles have become increasingly visible within the Indian alternative investment landscape.

Extending Beyond Listed Equities: The India Infinite Approach

At Green Portfolio, our journey began with disciplined public-market investing. Over six years, we focused on identifying strong businesses early within listed markets.

With the launch of the India Infinite Fund, we extended that investing excellence into private markets through a Category III open-ended AIF structure.

This allows participation in:

• Pre-IPO investments
• Preferential allotments
• Founder-backed growth rounds

The focus is sector agnostic yet manufacturing oriented, reflecting conviction in India’s long-term industrial expansion.

The Category III structure simplifies taxation for investors while enabling access to exclusive opportunities typically available only to institutional alternative investment partners.

For investors exploring alternative investment funds India offers, structural clarity matters as much as opportunity quality.

PMS vs AIF: Understanding the Role of Each

Many investors researching AIFs are simultaneously evaluating PMS structures.

Questions often arise around:

• PMS minimum investment requirements
• The minimum investment for PMS compared to AIF
• Whether to invest in PMS or allocate to private markets
• Identifying the best PMS to invest based on risk appetite

While PMS in investment portfolios provides direct ownership of securities and greater transparency, AIFs offer pooled access to differentiated private and structured opportunities.

The choice is rarely binary. In a well-constructed strategic portfolio, both can coexist, each serving a different role within broader asset allocation.

What matters is alignment with goals, risk tolerance, liquidity needs, and tax structure.

The Smart Investor’s Framework for 2026

Before committing capital to any AIF, ask:

How is taxation structured?
Will I face annual tax outflows?
How does the structure affect compounding?
Is the quoted return pre-tax or post-tax?
Does this allocation strengthen my long-term strategic portfolio?

The Indian alternative investment market is evolving rapidly. Investors who understand structure, not just strategy, position themselves more intelligently.

Final Thought: Structure Is Strategy

In 2026, alternative investments are no longer niche. They are becoming central to sophisticated wealth creation.

But performance without structural awareness can mislead.

Whether you are exploring Category I venture exposure, Category II private equity, or Category III market-linked opportunities, taxation determines how efficiently capital compounds.

At Green Portfolio, we believe capital deserves thoughtful allocation, across public and private markets, with clarity on structure, governance, and taxation.

Because in the end, wealth is not built on gross returns.

It is built on what remains after structure does its work.