When Your Fund Makes Money, Who Pays the Tax?

Quick answer

It depends on how the fund is set up. In a Category I or II fund, you pay tax on your share of what the fund earns, as if you had made the investment yourself. In a Category III fund, the fund pays the tax before the money reaches you.

Say you invest ₹10 lakh in a Category II fund. The fund buys shares in an unlisted company and sells them three years later, and your share of the profit is ₹5 lakh. The fund does not pay tax on that profit. You do, exactly as if you had bought and sold those shares yourself. The law calls this pass-through taxation: the income passes through the fund to you and keeps its character.

Before paying you, the fund deducts 10%, here ₹50,000. That is tax deducted at source (TDS), an advance towards your tax. It is not the final figure. Your actual tax on a ₹5 lakh long-term gain is 12.5% plus 4% cess, which is ₹65,000, so you pay the remaining ₹15,000 when you file your return.

A Category III fund works differently. It is taxed as a trust: the trustee is taxed on the fund’s income on behalf of the investors (the law calls the trustee a representative assessee), so the tax is paid inside the fund, before it shows up in the fund’s value per unit (its NAV).

Keep in mind: A Category I or II fund’s business income is not passed through: the fund itself is taxed on it. And the rates depend on the kind of income, so a dividend or interest payout is taxed differently from a long-term gain.

The example, worked through

Resident individual, total income up to ₹50 lakh (no surcharge)
Step	Amount
Your share of the gain	₹5,00,000
Tax at 12.5%	₹62,500
Add 4% health and education cess	₹2,500
Your total tax (the liability)	₹65,000
Deducted by the fund before paying you (TDS at 10%)	₹50,000
Paid by you with your return	₹15,000
Cash you receive from the fund	₹4,50,000
What you keep after all tax	₹4,35,000

How each structure works

Structure	Who holds the investments	Who is taxed on the fund’s income	Who deducts tax	What you do
Category I or II AIF (SEBI or GIFT IFSC)	The fund	You, on your share	The fund, before paying you	Report your share in your return, using the fund’s statement, and pay any balance
SEBI Category III AIF	The fund	The trustee, for the investors	The trustee pays tax at fund level	Keep the fund’s statements; a gain on redeeming your units is your own capital gain
GIFT IFSC Category III fund, retail scheme or ETF, all non-resident investors (a specified fund)	The fund	The fund, on its Indian income	The fund pays its own tax	As a non-resident, nothing from the fund or its units is included in your Indian income
GIFT IFSC Category III fund with resident investors	The fund	The trustee, for the investors	As for a trust	As for a trust; a gain on redeeming your units is your own capital gain
SEBI PMS	You: the shares are in your name	You, as a direct investor	Depends on the income and your residence	Report each sale and dividend in your return

Work out your own figure in the calculator

Legal provisions and technical details

The pass-through rule is section 224. The fund’s own exemption, which excludes business income, is Schedule V, Sl. 1. The fund’s 10% deduction is section 393, Table Sl. 4(iii). Trust taxation comes from sections 303, 304 and 307.

Section 224(1): pass-through for investment funds

224. (1) Irrespective of anything contained in any other provision of this Act and subject to the provisions of this section, where a person, being a unit holder of an investment fund, out of investments made in the investment fund, receives any income or any income accrues or arises to him, such income shall be chargeable to income-tax in the same manner as if, it were the income accruing or arising to, or received by, such person, had the investments made by the investment fund been made directly by him.