A significant legislative initiative, the Corporate Laws (Amendment) Bill, 2026, currently under review by a Joint Parliamentary Committee, signals a potential paradigm shift in the operational and tax landscape for Alternative Investment Funds (AIFs) in India. Specifically, the proposed amendments are set to provide a much-anticipated pathway for Securities and Exchange Board of India (SEBI)-regulated trusts to convert into Limited Liability Partnerships (LLPs), directly addressing a long-standing structural impediment for Category III AIFs and offering a considerable reduction in their effective tax burden. This move, if enacted, could foster greater capital efficiency and enhance India’s appeal as a hub for alternative asset management.
Alternative Investment Funds represent a crucial component of India’s burgeoning financial market, channeling capital from sophisticated investors – typically high-net-worth individuals, family offices, and institutional investors – into a diverse array of non-traditional assets. These include private equity, venture capital, hedge funds, real estate, and distressed assets, offering diversification and potentially higher returns than conventional listed equities and bonds. SEBI categorizes AIFs into three distinct classes based on their investment strategies and regulatory framework. Category I AIFs focus on early-stage ventures, SMEs, and infrastructure, often enjoying government incentives. Category II AIFs are broader, investing in equity and debt, but generally without undertaking leverage. It is Category III AIFs, however, that stand out for their complex, often high-risk, high-return strategies, frequently employing leverage and engaging in diverse trading strategies, including long-short equity, credit, and derivatives. As of March 2026, Category III AIFs alone had garnered commitments worth an impressive ₹3.15 trillion, underscoring their substantial role in the capital markets and the urgent need for a more streamlined regulatory and tax regime. The overall AIF sector in India has experienced robust growth, with total commitments across all categories more than doubling in the last five years, reflecting the increasing appetite for alternative investments among both domestic and international investors.
The core of the issue for Category III AIFs has historically been their tax treatment. Unlike Category I and II AIFs, which largely benefit from a ‘pass-through’ status (meaning the fund itself is not taxed, but investors are taxed on their share of income), Category III AIFs are typically taxed at the fund level. This has resulted in a significant tax leakage, as these funds pay taxes before distributing proceeds to their investors. The effective tax rate for many Category III AIFs structured as trusts can soar to as high as 39%. This contrasts sharply with the pass-through treatment enjoyed by other AIF categories, where long-term capital gains might be taxed at rates around 12.5% and short-term gains at 20% at the investor level.
The elevated tax burden for Category III AIFs stems primarily from a 2014 circular issued by the Central Board of Direct Taxes (CBDT). This circular stipulated that if a trust deed failed to precisely identify its beneficiaries and their beneficial interests at the time of incorporation, it could be classified as an ‘indeterminate trust’ and consequently taxed at the Maximum Marginal Rate (MMR). Even ‘determinate trusts’ (those that specify investors at inception) earning business income were subjected to MMR. This interpretation created a structural dilemma for AIFs, particularly Category III funds, which often cannot pre-determine all beneficiaries at their inception due to the dynamic nature of fund raising and investor onboarding. The MMR for fiscal year 2026, under the prevailing tax regime, can reach 39%, comprising a 30% base tax, a 25% surcharge on income exceeding ₹2 crore, and a 4% health and education cess. This makes India’s tax environment for certain AIFs considerably less competitive compared to global financial centers like Singapore or Luxembourg, which offer highly favorable tax regimes for investment funds to attract capital.
The proposed amendment to the Corporate Laws Bill aims to resolve this structural issue by explicitly permitting specified SEBI-regulated trusts to convert into LLPs. This legislative clarity is pivotal, as LLPs are assessed at a base rate of 30%, leading to an effective tax rate of approximately 35% after considering surcharges and cess. This difference represents a potential tax arbitrage of 3-5% for funds generating significant business income, a substantial saving that could directly enhance investor returns. As S.R. Patnaik, head of taxation at Cyril Amarchand Mangaldas, noted, an LLP structure offers a clear rate advantage for funds with considerable business income, moving away from the often punitive MMR applied to trusts. Experts like Sameer Gupta, national tax leader at EY India, have highlighted that Category III AIFs employing long-short strategies have historically preferred LLPs where possible due to the lower tax incidence and enhanced certainty, indicating a pre-existing market preference for this structure. Furthermore, LLPs provide greater predictability in taxation compared to trusts, whose tax framework was not originally designed for complex investment vehicles, thereby exposing funds and their investors to various tax risks.
Despite the clear tax advantages, the transition to an LLP structure is not without its trade-offs. While AIFs currently have the option to incorporate as LLPs, many have historically chosen the trust structure due to its perceived investor-friendliness and, crucially, the confidentiality it offers. Investors in alternative funds, particularly high-net-worth individuals and family offices, often value privacy, which can be compromised under an LLP framework where partners’ identities are typically publicly disclosed. This concern was voiced by an AIF executive who, while acknowledging the excitement among Category III funds for the LLP option, also noted that some Category I and II funds with foreign limited partners appreciate the flexibility, but also the discretion, offered by existing structures. The question of whether the tax benefits outweigh the loss of confidentiality will be a critical consideration for fund managers and their investors.
Moreover, industry participants do not anticipate a mass migration of all Category III AIFs to the LLP model. Sumeet Hemkar, partner at Deloitte India, emphasized that fund managers would need to meticulously evaluate several factors before initiating such a conversion. These include ensuring the conversion is tax-neutral, understanding the treatment of ‘carried interest’ and investor distributions, addressing operational complexities related to the admission and exit of investors, considering investor preferences, and assessing the overall transition costs. If the costs and operational hurdles associated with conversion outweigh the projected tax benefits, existing large funds may opt to retain their trust structure. Consequently, the industry is more likely to witness a selective migration rather than a wholesale shift. Some AIF officials have also suggested that a more direct solution, such as granting Category III AIFs outright pass-through taxation or reducing the MMR to a flat 30% for these funds, would be a superior proposition, circumventing the need to compromise investor confidentiality.
A significant lacuna in the current bill, however, is its silence on the taxation of ‘carried interest’. Carried interest, representing the share of investment profits allocated to fund managers as a performance incentive, has been a contentious issue in India for years, existing in a legal grey area. Neither the Income-tax Act nor the Goods and Services Tax (GST) law explicitly defines its tax treatment, leading to concerns among fund managers that tax authorities could reclassify it as service income rather than investment income. This ambiguity creates uncertainty and potential for disputes, hindering the long-term growth and stability of the alternative investment sector. Globally, the taxation of carried interest varies widely, with some jurisdictions treating it as capital gains (often at lower rates) to incentivize risk-taking and long-term investment, while others categorize it as ordinary income. The industry had ardently hoped that the Corporate Laws (Amendment) Bill would provide much-needed clarity on this critical aspect, especially given its direct impact on fund manager compensation and, by extension, the attractiveness of India’s asset management landscape. The absence of specific provisions leaves this "bigger unresolved tax problem" unaddressed, as noted by Nandini Pathak, partner at Bombay Law Chambers, who reiterated that carried interest is a commercial construct not intended to interfere with the tax pass-through structure of Category I and II AIFs. The continued lack of clarity on carried interest remains a key concern for the industry, potentially tempering the enthusiasm generated by the LLP conversion option.
Looking ahead, the Corporate Laws (Amendment) Bill, 2026, marks a progressive step in rationalizing the tax structure for Category III AIFs. By facilitating the conversion of trusts into LLPs, it provides a tangible path to reduce the tax burden from 39% to 35%, aligning India’s alternative investment framework more closely with international best practices in terms of tax efficiency for such vehicles. This reform is expected to enhance India’s competitiveness as an investment destination, potentially attracting more domestic and foreign capital into alternative assets. However, the success of this measure will hinge on fund managers’ careful evaluation of the trade-offs, particularly between tax savings and investor confidentiality, as well as the practicalities and costs of conversion. The continued ambiguity surrounding carried interest taxation suggests that while a significant structural hurdle is being addressed, the journey towards a fully harmonized and globally competitive tax regime for India’s burgeoning alternative investment sector is far from complete. Further legislative refinements and clarifications will likely be required to unlock the sector’s full potential and solidify India’s position on the global alternative asset management map.
