Carried interest in India: structuring and taxation for fund managers

Carried interest is the single largest driver of a fund manager’s personal wealth, and also the least settled item on an Indian fund’s tax position. A tax tribunal ruling involving a set of Indian venture capital funds once recharacterised carry as a service fee rather than investment income, and that uncertainty has never been fully closed by legislation. The Finance Act 2025 addressed a related but narrower question, whether securities held by a Category I or II Alternative Investment Fund (AIF) are capital assets, and left the manager-level characterisation of carry substantially where it was: a strong, well-supported industry position, but not a codified certainty. This article sets out where the law actually stands in 2026, what changed and what did not, and how fund managers should structure the entity that receives carry, vest it across a team, and manage GST and cross-border exposure.

How is carried interest currently taxed in India?

Carried interest received by an Indian fund manager is, as a matter of prevailing industry practice, taxed as capital gains at rates of 12.5 percent for long-term gains under Section 112A or 20 percent for short-term gains under Section 111A, depending on the holding period and the underlying asset class of the fund’s investments. This treatment rests on the position that carry is a disproportionate share of the fund’s own capital gains, distributed to the manager through the AIF’s pass-through mechanism under Section 115UB, and therefore takes the same character as the gain in the fund’s hands.

That position has never been free of risk. Carry is typically structured as a special class of units or interests in the AIF, held by the manager or sponsor entity, entitling it to a share of profits once investors have received back their capital and a preferred return (the hurdle rate, commonly 8 percent per annum for Category II funds). Because the manager holds these units in exchange for providing investment management services rather than for a proportionate capital contribution, tax authorities have periodically argued that carry is compensation for services dressed up as a return on investment. This is not a hypothetical academic debate. It has already been litigated once, and the outcome was not favourable to the industry’s preferred position.

What did the Finance Act 2025 amendment actually change?

The Finance Act 2025 amended Section 2(14) of the Income-tax Act, 1961 to expressly include securities held by an investment fund referred to in Section 115UB (Category I and Category II AIFs, whether SEBI-registered or IFSCA fund management entities) within the definition of a capital asset. This closed a long-running ambiguity over whether gains from an AIF’s securities transactions were capital gains or business income at the fund level, and it applies from assessment year 2026-27, that is, financial year 2025-26 onward.

What this amendment does not do is legislate the tax character of carried interest in the manager’s hands as a distinct question. It fixes the character of the fund’s own income. Carried interest is then taxed in the manager’s hands with the same character as the fund’s income under the pass-through mechanism in Section 115UB, provided the carry is correctly structured as a share of the fund’s distributable proceeds rather than as consideration for a separately identifiable service. In practice, this means the 2025 amendment strengthens the industry’s existing position considerably, since there is now a statutory anchor for treating the fund’s gains as capital gains, but it does not eliminate the risk that a tax officer treats the manager’s carry allocation as a fee for investment management services rendered, a risk that predates and survives this amendment.

Is carried interest capital gains or business income for the fund manager?

Carried interest is capital gains in the fund manager’s hands when it can be shown to be a share of profits from the fund’s own capital-asset transactions, distributed under the Section 115UB pass-through mechanism, and it risks recharacterisation as business income or professional fee income when the underlying facts suggest the carry is compensation for a service rather than a return on a genuine capital interest.

The precedent that fund managers should know is a tax tribunal ruling involving a set of venture capital funds, where carried interest was held to be neither interest nor a return on investment, but consideration retained by the fund for services rendered to investors and passed on to the fund manager. The tribunal reasoned that the fund manager, sponsor, and trustee were all common entities, and that the fund manager’s investment in the special class of units carrying the carry entitlement had been made after returns had already been substantially earned, undermining the claim that the manager bore genuine investment risk from inception.

The practical test that emerges from this and subsequent commentary turns on a small number of factual markers:

• Whether the manager’s carry-class units were subscribed at the same time as, or materially later than, the investor units, since a late or nominal subscription weakens the capital-contribution argument
• Whether the manager bears genuine downside, that is, whether carry is subject to a real clawback if the fund underperforms in later years, or whether it is effectively guaranteed once triggered
• Whether the sponsor and manager entities are commercially and legally distinct from each other and from the trustee, since common control across all three roles increases scrutiny
• Whether the carry entitlement is documented as a unit class with the same rights, risks, and reporting as other unit classes, rather than as a separate side letter tied to services rendered

If the tax office recharacterises carry as a fee, the effective tax cost rises sharply. Carry taxed as business income for a company or LLP manager runs at 25 to 30 percent depending on the entity’s form, and if GST is layered on top as a service fee, the combined effective rate on carry has been estimated in professional commentary at 43 to 47 percent, against roughly 14.95 percent for long-term capital gains at the 12.5 percent rate plus applicable surcharge and cess for high-income individuals. That gap, in the range of 28 to 32 percentage points, is the entire reason structuring discipline on carry documentation matters more than almost any other drafting decision in the fund’s formation documents.

Effective tax rate on carry under alternative characterisations

Characterisation	Applicable provision	Approximate effective rate	Key risk factor
Long-term capital gains	Section 112A, Income-tax Act 1961	14.95% (12.5% plus surcharge and cess at higher slabs)	Requires genuine capital-unit structuring and holding period
Short-term capital gains	Section 111A, Income-tax Act 1961	Approximately 23.92% (20% plus surcharge and cess)	Applies where fund’s holding period on the underlying asset is short
Business income (company/LLP manager)	Normal corporate/LLP tax rates	25% to 30% plus surcharge and cess	Triggered where carry is recharacterised as management fee income
Business/professional income with GST layered	Section 9, CGST Act 2017 (if mutuality is defeated)	Approximately 43% to 47% combined	Applies if both income tax recharacterisation and GST liability are triggered

Does GST apply to carried interest?

GST does not apply to carried interest where the fund is structured as a trust and the doctrine of mutuality applies, since the fund and its contributors are not treated as separate persons for the purposes of a taxable supply, but this protection is narrower and more contested than fund managers often assume.

The doctrine of mutuality holds that a person cannot supply a service to themselves, and Indian courts have historically applied this to trust-investor relationships on the reasoning that the trust merely holds and invests contributors’ money on their collective mandate, without an independent commercial transaction taking place. A High Court, ruling on a batch of venture capital fund appeals, held that the fund does not perform a service to its investors and applied the mutuality doctrine to override an earlier tribunal order that had equated carried interest with a performance fee liable to service tax. The Supreme Court subsequently declined to disturb this position on the specific point that a trust is not a separate person from its contributors for this purpose.

Two qualifications matter for a fund manager relying on this protection. First, the mutuality ruling addresses the fund-to-investor relationship. It does not, on its own, resolve whether the fund-to-manager carry distribution is itself a taxable supply, since the manager and the fund are more clearly separate persons than the fund and its own contributors are. Second, the CGST Act’s deeming provisions in Section 7(1)(aa), which treat transactions between an association and its members as a supply, have themselves been under constitutional challenge, with a High Court striking down the provision as unconstitutional in April 2025. As of the date of this article, the matter remains pending before the Supreme Court with no stay granted on the High Court’s ruling, so the position remains favourable but not finally settled. A fund manager should treat the GST position on carry as favourable on current authority but not closed, and should build a documented legal opinion into the fund’s formation file rather than relying on the trust structure alone.

• One list-check before signing off a carry structure: confirm the AIF is genuinely constituted as a determinate trust with identifiable beneficiaries, since indeterminate trust structures forfeit several of the tax and GST protections discussed here
• Confirm the investment management agreement between the trustee and the manager does not describe carry as consideration for services in its operative clauses, even where the commercial substance is a profit share
• Confirm the manager’s carry-class subscription is documented and funded on terms consistent with a genuine capital contribution, not merely a nominal unit issued to create the appearance of one

Does a deal-by-deal or whole-fund waterfall change when carry is taxed?

A deal-by-deal waterfall crystallises carry earlier, as each portfolio investment exits, while a whole-fund waterfall defers carry until investors have received back their entire committed capital plus the hurdle across the fund as a whole, and this timing difference directly affects when the manager’s tax liability arises and how much clawback exposure sits behind an already-taxed distribution.

Under a deal-by-deal structure, the manager receives and is taxed on carry as each successful exit occurs, well before the fund’s overall performance across its full portfolio is known. This is attractive from a cash flow standpoint but creates a structural risk: if later investments in the same fund underperform, the manager may owe a clawback repayment on carry already received, taxed, and often spent. Under a whole-fund waterfall, carry is only paid once the fund has returned all contributed capital and the hurdle to investors on an aggregate basis, which defers the manager’s tax event but gives a materially more accurate picture of true economic entitlement at the point of payment. Indian LPs, particularly family offices and institutional investors, increasingly push for whole-fund waterfalls in Category II fund negotiations specifically to avoid clawback disputes.

Most Indian PPMs that do permit deal-by-deal carry build in an escrow or holdback mechanism to manage this risk: a portion of each interim carry distribution, commonly in the range of 20 to 30 percent, is held back in an escrow account rather than paid out immediately, and released to the manager only after a true-up calculation at fund windup confirms the manager’s aggregate entitlement across the full portfolio. Where such an escrow is properly structured, the amount held back is not treated as received by the manager, and the tax event does not arise until the escrowed amount is actually released, since Section 115UB’s pass-through mechanism operates on income paid or credited to the unit holder, not on income notionally accrued but withheld under a contractual condition. A manager relying on this deferral should confirm the escrow arrangement is genuinely restrictive, with the funds held by an independent escrow agent or the trustee rather than merely designated as “held back” on the manager’s own books, since a nominal holdback that the manager can access does not achieve the deferral.

The clawback repayment problem deserves separate attention. If a manager has already paid tax on carry that is later clawed back because the fund’s later investments underperform, Indian tax law does not offer a clean mechanism to recover the tax already paid on the repaid amount in the same way a capital loss carry-forward would. This is precisely why an escrow-based deal-by-deal structure, or a whole-fund waterfall that avoids the clawback scenario altogether, is now the preferred approach in most professionally negotiated Category I and II LPAs, rather than a deal-by-deal structure with no holdback at all.

How should a fund manager structure the entity that holds carry?

A fund manager should hold carried interest through the same entity that holds the sponsor or GP commitment wherever possible, using a company, LLP, or dedicated carry vehicle chosen to match the manager’s residency, GST registration status, and plans to bring in additional carry-earning team members, rather than defaulting to personal capacity without evaluating the alternatives.

Three structures are commonly used, and the right one depends on team size and cross-border exposure more than on tax rate alone, since the capital gains characterisation discussed above should, in principle, apply regardless of which of these vehicles holds the carry-class units.

Comparing carry-holding structures

Structure	Best suited for	Key advantage	Key limitation
Personal capacity (individual manager)	Solo or two-person GP teams with no plan to add carry-earning hires	Simplest to set up, no additional entity compliance	Cannot cleanly allocate carry across a growing team without repeated PPM amendments
LLP (management or carry-holding LLP)	Multi-partner GP teams wanting flexible profit-sharing without corporate rigidity	Profit allocation among partners is contractual and easily amended via the LLP agreement	LLP-level business income exposure if carry is ever recharacterised, since LLPs do not get capital gains slab benefits available to individuals
Dedicated carry vehicle (separate trust or company holding only the carry-class units)	Institutional managers running multiple fund vintages who want to ring-fence carry from operating entity liabilities	Isolates carry from the management company’s operating risk and creditor exposure; cleaner for a later sale of the management business	Adds one more entity to incorporate, maintain, and file returns for, with associated MCA and tax compliance

Where the fund itself is structured as an LLP or company rather than a trust, the choice of the AIF’s own legal form separately affects how the manager receives distributions; a trust-structured AIF distributes carry directly to the manager’s unit-holding entity, while a company-structured AIF distributes as a dividend, which carries its own withholding and characterisation consequences. Treelife has covered this fund-level structuring decision, trust versus LLP versus company, in detail in our comparison of AIF trust, LLP, and company structures, which should be read alongside this article before the fund’s legal form is finalised, since the carry vehicle decision and the fund’s own legal form interact directly.

How should carry be split and vested across an investment team?

Carry should be allocated to individual team members through a documented carry pool with time-based vesting, performance conditions tied to the fund’s own hurdle and waterfall, and an enforceable clawback, structured either as direct participation in the carry-class units or as a phantom carry arrangement that tracks the economics without transferring actual units.

Two structuring choices dominate in Indian fund practice. Direct participation gives each team member a proportionate interest in the same carry-class units the sponsor entity holds, typically through a sub-allocation agreement or a separate class of units if the trust deed permits multiple carry tranches. Phantom carry, more common for junior or mid-level team members, is a contractual bonus right calculated by reference to the carry actually received by the fund, without the team member holding any unit or partnership interest in the fund itself.

• Direct participation preserves capital gains characterisation for the team member individually, since they hold a genuine unit interest, but requires them to be named investors in the fund’s records and PPM, with attendant KYC and reporting
• Phantom carry is administratively simpler and avoids adding names to the fund’s investor register, but is almost certainly taxed as salary or business income in the recipient’s hands, since there is no underlying capital asset changing hands, only a contractual payment right
• Vesting schedules for either structure typically run four to five years, matched to the fund’s investment period, with cliff vesting in year one and a clawback triggering repayment of vested carry if the team member departs for cause before the fund’s realised performance is confirmed at exit

A carry pool that mixes these two mechanisms without clear documentation is the single most common source of post-exit disputes Treelife has seen in team transitions, since departing team members and the remaining GP frequently disagree on whether an informal understanding created a genuine unit interest or a discretionary bonus expectation.

The grant event is a separate tax question from the receipt of carry. Fund managers frequently focus only on how carry is taxed when it is eventually paid out, and overlook that the act of admitting a team member to the carry pool can itself be a taxable event. Where a team member who is an employee of the management company is admitted to carry-class units at less than their fair value, the difference can be treated as a perquisite under Section 17(2) and taxed as salary income at the time of admission, regardless of whether the fund has generated any actual profit yet. Where the recipient is not an employee, for instance a co-founder holding units through a separate entity, the same undervaluation can instead be tested under Section 56(2)(x) as income from other sources in the recipient’s hands. Structuring the carry pool with a fair value subscription price for units at the time of admission, supported by a contemporaneous valuation, avoids creating an unintended tax liability years before any carry is actually realised. This is a distinct and additional risk on top of the eventual characterisation of the carry receipt itself discussed earlier in this article.

What FEMA and cross-border rules apply to fund manager carry?

An NRI or foreign national acting as the investment manager of an Indian AIF must comply with the Foreign Exchange Management Act, 1999 on inward and outward remittances covering both management fees and carried interest, regardless of whether the manager is structured as an individual, LLP, or company, and regardless of the AIF’s own legal form.

For a non-resident manager receiving carry from an Indian fund, the remittance route and any withholding depend on whether the carry is paid to an Indian entity that the non-resident controls or directly to an offshore entity. Where carry flows to an offshore management entity for services rendered wholly outside India, tax treaty provisions may exempt the payment from Indian tax altogether if the relevant double taxation avoidance agreement requires services to “make available” technical knowledge for a fee to be taxable in India and the manager’s role does not meet that threshold, a structuring opportunity that has existed in commentary for over a decade but requires treaty-specific analysis before being relied upon.

GIFT City adds a further structuring layer for managers running or planning to run offshore-facing funds. A Fund Management Entity registered under the IFSCA (Fund Management) Regulations, 2025, whether an Authorised FME, a Registered Non-Retail FME, or a Registered Retail FME, can hold and manage carry-class interests in schemes launched under the IFSCA framework, often with the benefit of the business income tax exemption available to eligible FMEs for a specified period, and with more straightforward foreign currency capital contribution mechanics than a SEBI-domestic AIF managing predominantly foreign LPs. Managers with a meaningful non-resident LP base should evaluate a GIFT City FME structure alongside, not instead of, their domestic SEBI AIF registration, since the two can operate as parallel or feeder structures depending on the fund’s target investor base.

Common mistakes that cost fund managers time and money

Treating the carry clause as a commercial afterthought in the LPA. Many first-time managers negotiate hurdle rate, catch-up percentage, and carry split in detail but leave the tax characterisation language generic. Once the fund has closed, the trust deed and PPM cannot be amended to retroactively strengthen the capital-contribution argument, so this has to be right from drafting stage.

Subscribing to carry-class units late or at a nominal value. Where the manager’s carry units are subscribed well after the fund’s first close, or at a value that does not reflect a genuine investment commitment, this is precisely the fact pattern that has supported recharacterisation as a fee in prior tribunal rulings. Subscribe alongside the fund’s other investors wherever the fund’s timeline permits.

Assuming GST exemption is settled law. The mutuality doctrine gives fund managers a strong current position on GST, but the Kerala High Court ruling on Section 7(1)(aa) is under Supreme Court appeal, and the fund-to-manager relationship was never squarely the subject of the Karnataka High Court’s ruling. A manager who treats this as closed risks an unbudgeted GST demand with interest running from the original distribution date.

Using phantom carry for senior team members who expect capital gains treatment. Phantom carry is administratively convenient but is taxed as ordinary income. Senior hires who negotiate “carry” as part of their compensation package should have the actual tax character of what they are being offered made explicit before they accept, to avoid disputes at the point of the first meaningful distribution.

Ignoring the interaction between the carry vehicle and the fund’s own legal form. A carry-holding LLP receiving distributions from a company-structured AIF receives a dividend, not a pass-through capital gain, and the LLP-level tax treatment of that dividend differs materially from what the manager may have modelled when the fund was set up as a trust. Confirm this interaction before, not after, the fund’s legal form is locked. For the fund-level comparison, see Treelife’s AIF taxation guide, which sets out category-wise and structure-wise tax treatment for the fund and its investors.

Case study

Situation: A first-time Category II private credit fund manager based in Mumbai, raising a ₹150 crore fund from domestic family offices and HNIs, structured the fund as a trust with a standard 2 and 20 fee arrangement.

Challenge: The draft PPM described carry only in commercial terms, with no clause characterising the manager’s carry-class units as capital contributions, and the manager planned to add two portfolio managers mid-fund life through informal profit-sharing letters rather than a documented carry pool.

What Treelife did: Redrafted the trust deed and PPM to include an express capital-contribution characterisation clause for the carry-class units, structured the manager’s carry subscription concurrent with the fund’s first close, and built a documented carry pool with four-year vesting and clawback for the anticipated team additions, using direct unit participation rather than phantom carry.

Outcome: The fund closed with a carry structure that withstood a subsequent SEBI PPM audit query on unit-class documentation without amendment, and the two portfolio managers added at month eight held genuine capital gains-eligible interests rather than contractual bonus rights, avoiding a later renegotiation at exit.

Frequently asked questions

Q: What is the current tax rate on carried interest in India?
A: Carried interest is taxed at 12.5 percent as long-term capital gains under Section 112A or 20 percent as short-term capital gains under Section 111A, depending on the fund’s holding period on the underlying asset, plus applicable surcharge and cess.

Q: How much does Treelife charge to review or structure carry documentation?
A: Advisory fees for carry structuring are typically scoped against the complexity of the fund’s legal form and team size and are quoted after an initial review call rather than as a fixed published rate, since a solo-manager trust and a multi-partner LLP carry pool require materially different drafting work.

Q: How long does it take to restructure a carry vehicle before a fund’s first close?
A: A carry-holding entity, whether a new LLP or a dedicated vehicle, can typically be incorporated and documented within three to four weeks, provided it runs in parallel with the fund’s own SEBI registration and PPM finalisation rather than sequentially after it.

Q: What documentation should a fund manager maintain to support capital gains characterisation of carry?
A: The trust deed or fund constitutional document, the PPM’s carry and unit-class clauses, the manager’s subscription agreement and payment proof for carry-class units, and the fund’s distribution waterfall statements showing carry paid pari passu in character with investor distributions.

Q: Does the Finance Act 2025 amendment apply to Category III AIFs as well?
A: No. The Section 2(14) amendment applies specifically to investment funds referred to in Section 115UB, which covers Category I and Category II AIFs. Category III AIFs do not have a statutory pass-through regime and are taxed differently at the fund level; see Treelife’s Category III AIF taxation guide for that treatment.

Q: Is carried interest subject to FEMA reporting for a resident Indian manager?
A: FEMA reporting obligations for carry arise primarily where the manager or LPs are non-resident, or where carry is remitted offshore. A purely domestic manager receiving carry from a domestic AIF with domestic LPs generally has no separate FEMA filing solely on account of the carry distribution itself.

Q: Can a family member or co-founder of the fund manager hold a share of carry directly?
A: Yes, provided the family member or co-founder is admitted as a unit holder in the carry class through the same documentation and subscription process as other carry participants. Informal arrangements outside the fund’s unit register do not carry the same capital gains protection.

Q: What happens to unvested carry if the fund’s investment period ends before a team member’s vesting is complete?
A: This depends entirely on the carry pool agreement’s drafting. Well-drafted agreements tie vesting to time in role and to the fund’s realised performance milestones independently, so that the end of the investment period does not automatically vest or forfeit carry; poorly drafted agreements leave this ambiguous and become a common point of dispute at exit.

Q: How does carried interest interact with DPIIT startup tax exemptions?
A: It does not directly. DPIIT recognition and the associated tax holiday under Section 80-IAC apply to eligible startups themselves, not to fund managers or AIFs. A fund investing in DPIIT-recognised startups does not pass any startup exemption through to the manager’s carry.

Q: What if the fund’s LPs and the manager disagree on whether carry should be structured with direct participation or phantom carry for the team?
A: This is a governance point that should be resolved in the LPA before the fund closes, since LP advisory committees increasingly expect visibility into how carry is allocated across the GP’s team as part of key-person and alignment provisions, not left to the manager’s sole discretion after closing.

Q: Are NRI fund managers taxed differently on carry than resident managers?
A: The underlying capital gains characterisation is the same, but a non-resident manager’s carry may additionally be subject to treaty analysis under the applicable double taxation avoidance agreement, and remittance is subject to FEMA reporting that does not apply to a resident manager.

Q: What is the risk if a fund manager’s carry-class units are found to be a device rather than a genuine capital interest? A: The carry allocation is recharacterised as business or professional income, taxed at the manager’s applicable slab or corporate rate, and GST may additionally apply if the arrangement is treated as consideration for a taxable supply of management services, materially increasing the effective tax cost as set out in the rate comparison table above.

Q: Is admitting a team member to the carry pool itself a taxable event?
A: It can be. If a team member is admitted to carry-class units at less than fair value, the shortfall may be taxed at the time of admission as a perquisite under Section 17(2) for employees or under Section 56(2)(x) for non-employees, independently of whether the fund has yet earned any carry. A fair value subscription at admission avoids this.

Q: If carry is held back in escrow under a deal-by-deal waterfall, is it taxed before it is actually paid to the manager?
A: Generally no, provided the escrow is genuinely restrictive and administered by an independent party or the trustee, since Section 115UB taxes pass-through income on the basis of amounts paid or credited to the unit holder, not amounts notionally accrued but withheld under a contractual holdback pending a fund-level true-up.

Regulatory references

• Section 2(14), Income-tax Act 1961, as amended by the Finance Act 2025
• Section 115UB, Income-tax Act 1961
• Section 194LBB, Income-tax Act 1961, renumbered as Section 393(1) under the Income Tax Act 2025, in effect from 1 April 2026
• Section 111A and Section 112A, Income-tax Act 1961
• Section 17(2), Income-tax Act 1961 (perquisite taxation on undervalued unit admission)
• Section 56(2)(x), Income-tax Act 1961 (income from other sources for non-employee unit admission at less than fair value)
• Section 7(1)(aa) and Section 2(17)(e), Central Goods and Services Tax Act 2017
• SEBI (Alternative Investment Funds) Regulations, 2012
• IFSCA (Fund Management) Regulations, 2025
• Foreign Exchange Management Act, 1999 and FEMA (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019
• CIT v. India Advantage Fund-VII and connected appeals, Karnataka High Court
• Indian Medical Association, Kerala State Branch v. Union of India, Kerala High Court, April 2025

External sources

• Income Tax India
• GST Council / CBIC
• SEBI
• Reserve Bank of India
• IFSCA
• E-gazette