OPINION | Budget 2026: Closing the tax gaps in India’s AIF framework 

The tax and regulatory framework for AIFs in India have been updated to provide greater transparency.

As India moves steadily toward its Viksit Bharat vision, the Union Budget 2026 becomes a critical opportunity to accelerate the country’s next phase of economic transformation. Alternative Investment Funds (AIFs) have witnessed

the sharpest growth as an avenue of investment in recent years.

Total assets under PMS and AIFs have surpassed approximately Rs 23 lakh crore in the current financial year. This trend clearly reflects a paradigm shift among investors from conventional asset classes to more sophisticated, deeper, and long-term focused portfolios.

Has enough been done to ensure investor-friendly taxation to attract further inflows? The Finance Ministry can use this Budget as an opportunity to bring parity in taxation and provide long-awaited clarity on the treatment of complex fund structures under the Income-tax Act. Below are the key industry expectations from a tax standpoint:

Extending the pass-through status 

A key area of concern is the need to bring tax parity for Category III AIFs. Despite their growing presence in India’s capital markets, these funds do not have a dedicated taxation framework under the Income-tax Act.

Most Category III AIFs are structured as trusts and are therefore governed by private trust taxation regimes that were never designed for institutional investment vehicles.

The lack of a dedicated regime has led to mismatches and inconsistencies in interpretation, prolonged disputes, and, in some cases, the risk of double taxation, where income is taxed both at the fund level and in the hands of investors. 

The Finance Act, 2015, introduced a special taxation regime by granting pass-through status to Category I and Category II AIFs. Further, the Finance Act, 2021, granted tax pass-through status to Category III AIFs incorporated in the IFSC.

It has been a long-standing expectation of the industry that the pass-through regime be extended to all Category III AIFs as well.

In order to bring tax parity among the three categories of AIFs, it is now expected that Budget 2026 will extend pass-through status to Category III AIFs. This would also ensure fair tax treatment for investors in Category III AIFs, as different surcharge rates may be applicable to individual investors, whereas taxation at the fund level could result in the entire income being taxed at the highest applicable surcharge rate.

Clarity on the characterisation of income from securities held by the Category III Fund

Historically, the issue of characterisation of income from transfer of securities held by the Category I, II and III AIFs, whether taxable as business income or capital gains, has been a subject of litigation.

The Finance Act 2025 has amended the definition of ‘Capital Asset’ to include securities held by Category I and II AIFs. Accordingly, any gains arising from the transfer of securities by Category I and II AIFs will be taxable as capital gains.

However, Category III AIFs would still face challenges on the characterisation of income, as these funds are not covered under the said amendment. There is therefore an expectation that Budget 2026 will introduce a similar amendment to remove this anomaly.

Specific exemption from indirect transfer provisions

Another key issue relating to Category III AIFs is the applicability of indirect transfer provisions under Section 9 of the Income-tax Act. Under these provisions, transfer of shares or interest in an offshore entity that derives its value, directly or indirectly, substantially from assets located in India is treated as an indirect transfer and is subject to capital gains tax in India.

Income arising to non-resident investors on account of redemption or buyback of their share or interest held indirectly, through upstream entities incorporated outside India, in Category I and Category II AIFs has been granted exemption from the provisions of indirect transfer by way of a clarification in Income-tax Circular No. 28/2017 dated 7 November 2017.

This clarification does not extend to Category III AIFs. Accordingly, to ensure a level playing field, Category III AIFs should also be kept outside the purview of the indirect transfer provisions.

Concluding remarks

The tax and regulatory framework for AIFs in India have been updated to provide greater transparency and precision in the interpretation of the law. As this sector is emerging as one of the most preferred alternative investment options, it must move at a global pace, thereby building trust, confidence and attracting wider participation through stable and predictable tax outcomes.

All eyes are on the upcoming Budget 2026 to provide these clarifications and relaxations to sustain investor interest in AIFs and maintain the momentum of inflows, in comparison with other alternative asset classes such as Mutual Funds and PMS.

- With inputs by CA Ritesh Podar.

(Manoj Purohit is Partner - Financial Services Tax, Tax & Regulatory Advisory, BDO India.)

Views are personal and do not represent the stand of this publication.