Tax on Income of Investment Fund and Its Unit Holders (Section 224)

Understand Tax on Income of Investment Fund and Its Unit Holders

Key rules to remember

Who is covered

Investment fund = Category I or Category II AIF (SEBI AIF Regulations)

Category III AIFs do not get this pass-through treatment. Check the category before applying section 224.

Split of fund income

Fund income = Business income + Income other than business income

This split decides everything else. Do it first.

Pass-through rule

Unit holder's taxable share = Fund's non-business income × unit holder's share (%), same character

Taxed as if the unit holder invested directly. Capital gains keep their short-term or long-term character. TDS on this income is separate: it applies only to income other than exempt and business income, and the rate depends on residence (see the TDS row).

Business income

Business income is taxed at fund level at the rate applicable to the fund's form

Not included again in the unit holder's total income when distributed.

Deemed credit

Pass-through income not paid or credited during the tax year is deemed credited to the unit holder on the last day of the tax year

Taxable in that tax year in the unit holder's hands whether or not paid out. It is not taxed again when later actually distributed.

TDS on payment to unit holder (section 393)

Investment fund deducts TDS on income paid or credited, other than exempt income and business income: resident unit holder 10%; non-resident, the rate in force for that income

The fund itself, as the person responsible for paying, deducts the tax. TDS arises when income is actually paid or credited, not on a share merely deemed credited at year end. Verify the current rate against the Income-tax Act, 2025 text.

Losses

Fund's business loss is not passed to unit holders; it is carried forward at the fund. Any set-off at fund level follows the normal set-off rules. Income under other heads is computed after permitted set-off at fund level, and any resulting loss stays at the fund

Unit holders cannot set off the fund's loss against their own income.

How to solve Tax on Income of Investment Fund and Its Unit Holders questions

1. 1Confirm the fund is a Category I or II AIF. If it is Category III, section 224 does not apply.
2. 2List all income of the fund for the tax year and classify each item as business income or income other than business income.
3. 3Tax the business income at the fund level using the rate that suits the fund's form (company, firm or trust). Do not pass a business loss of the fund to unit holders. It is carried forward at the fund, and any set-off at fund level follows the normal set-off rules or the facts given in the question.
4. 4Pass the non-business income to unit holders. For each head, take the fund's income after the permitted set-off at fund level. Multiply each item by the unit holder's share and keep its character, such as interest, dividend, short-term or long-term capital gain.
5. 5Add the passed-through items to the unit holder's own income under the right heads. Include amounts not paid or credited during the year as deemed credited on the last day of the tax year.
6. 6Do not tax business income again in the unit holder's hands, and do not tax deemed-credited income again when it is later distributed.
7. 7Compute TDS (section 393) on the income actually paid or credited to the unit holder, other than exempt income and business income: 10% for a resident, the rate in force for a non-resident. Do not compute TDS on a share that is only deemed credited. Show the TDS as a credit against the unit holder's tax. Check the current rate against the Income-tax Act, 2025 text.
8. 8State any fund loss (business loss, or a loss left under another head) as carried forward at the fund, not passed to the unit holder.

Quickest way: Split, pass, tax, deduct

Common mistakes in Tax on Income of Investment Fund and Its Unit Holders

• Passing the fund's business income to unit holders and taxing it again.

  Students assume everything the fund earns is pass-through.

  Fix: Remember the split. Business income is taxed at the fund. Only non-business income passes through.

• Giving unit holders a share of the fund's loss.

  Pass-through feels like it should work for gains and losses alike.

  Fix: State that the business loss and any loss left under another head stay at the fund and are carried forward there. Unit holders cannot claim them.

• Taxing only the amount actually distributed.

  Students link tax to cash received.

  Fix: Pass-through income not paid or credited in the year is deemed credited to the unit holder on the last day of the tax year. Include it. But do not tax it again when it is later distributed.

• Changing the character of income, for example treating a capital gain as other-sources income.

  Students treat the payout from the fund as one lump sum.

  Fix: Keep the original character. A long-term gain in the fund is a long-term gain for the unit holder.

• Applying section 224 to a Category III AIF.

  Students read AIF and stop checking the category.

  Fix: Check the category first. The regime is for Category I and II funds.

• Deducting TDS on business income, computing TDS on a share that was only deemed credited, or using the wrong rate.

  Students apply TDS to the full pass-through share and forget the residence test.

  Fix: TDS applies to income other than business income that is actually paid or credited. Use 10% for residents and rates in force for non-residents.

Worked examples