PFIC Taxes on Mutual Funds Investments in India

In india, dividends are tax free; long term capital gains on equity funds are also tax free. Plus, opening and operating accounts online has simplified the investment process for a lot of Indians who live abroad. See  A Simple Guide to the Stock Market Investing in India on how easy it is to open a mutual funds account in India. However, if you are a NRI living in the US, you will need to be very cautious about investing in the Indian Mutual funds. You won't face any issues while opening accounts in India, BUT, you will face issues while filing tax returns to the IRS. The matter gets complicated due to tax treatment and classification of foreign mutual funds as Passive Foreign Investment Company (or PFICs).

What is Passive Foreign Investment Company (PFIC)

A foreign corporation is a PFIC if it meets either the income or asset test described below.

Income test

75% or more of the corporation's gross income for its taxable year is passive income, which is based on investments rather than standard operating business. All mutual funds (including bond mutual funds) qualify as a PFIC as their sole purpose is to generate passive income from investments in companies rather than through the standard operating business.

Asset test

At least 50% of the average percentage of assets  held by the foreign corporation during the taxable year are assets that produce passive income or that are held for the production of passive income. This second factor closes any remaining gaps for all mutual funds.

Is LIC a PFIC

PFIC is not simply limited to mutual funds and can also apply to certain individual stocks or even life insurance products and annuities. According to IRS' definition of PFIC, LIC can be considered a PFIC. All LIC policies that pay you cash regularly or in lump-sum at maturity, pool the premiums and invest them in other companies or government entities. LIC's income is therefore passive income, and I would assume 50% of LIC's investments produce interest, dividend, or capital gains. For this reason, LIC should be treated as a PFIC. Of course, I have no way of confirming this directly nor could I find any information from LIC's website. But, since their mainstream clientele is based in India and not in the US, it may not be in their best interest to publish this information. Therefore, I can only infer that LIC is a PFIC based on my knowledge and research about PFICs.

How Are PFICs Taxed

You can choose from one of the three alternatives.

Excess Distributions Method

This is the default method unless one of the alternatives is elected by the taxpayer. The basic premise of this method is that you pay no tax until you cash out. But, when you sell your investments, all income and capital gains are taxed at the highest ordinary income rate (35% in 2012). Also, all of the capital gains are subject to tax treatment over the time the investment was held even though the fund made money only during the few years. Since, you do not incur capital gains taxes until you sell your investments,  9% to 10% compounded interest is charged on deferred taxes. Essentially, you could be looking at 35% taxes on capital gains, plus, compounded annual interest of 9-10% on deferred capital gains for each year you held your investments.

Mark-to-Market Method

This method allows an owner of PFIC shares to mark gains to market at year end. Essentially, with this method, you pay taxes on the difference between the value of your investments at the beginning of the year and the value of your investment at the end of the year, and you start fresh each January 1st. You are paying as you go each year. Capital gains are treated as ordinary income, and not at the rate of long-term capital gains taxes. This method also requires the investor to keep record of the value of the investments each year.

Qualified Electing Fund Method

If the PFIC meets certain accounting and reporting requirements, you can elect to treat the PFIC as a qualified electing fund. The effect is that the PFIC shares are taxed like US shares. So, a foreign mutual fund treated as a QEF is taxed just like any other US mutual fund. While this sounds easy, it is extremely unlikely that IRS will accept your PFIC as QEF. The reason is that foreign mutual funds simply do not report information the way a US mutual fund would to SEC. For this reason, PFIC qualifying as QEF is extremely rare.

How To File PFIC Taxes

IRS Form 8621 must be filed along with your tax return. Generally, a US person that is a direct or indirect shareholder of a PFIC must file Form 8621 for each tax year in which that US person:

• Recognizes gain on a direct or indirect disposition of PFIC stock,


• Receives certain direct or indirect distributions from a PFIC, or


• Is making an election reportable in Part I of the form.

NOTE: A separate Form 8621 must be filed for each PFIC in which stock is held.

Why Should You Avoid PFICs

As discussed above, PFICs are subject to strict and complicated guidelines to discourage their ownership by US investors. This requires the shareholder to keep accurate records of all transactions, including cost basis, dividends and any undistributed income earned by the company.

Apart from the strict reporting requirements, the tax treatment of PFICs is extremely punitive compared to the tax treatment of similar mutual funds offered by US brokers. For example, if you held a US mutual fund (e.g. MINDX or EPI) that invests primarily in Indian stock market, then your long‐term capital gains will be taxed at 15% rate if you held it for more than one year. However, if you invested in an identical fund  (let's say Kotak Nifty Index ETF) listed in the Indian stock market, PFIC tax rules will treat all income (including capital gains) as ordinary income and you will be automatically taxed at the current highest individual tax rate (35%), plus compounded interest of 9-10% for deferred taxes for each year you have held the investment. Furthermore, your capital losses cannot be carried forward or used to offset other capital gains. For this reason alone, PFIC taxation rules will eat up all your extra earnings and you're probably worse off than if you had invested that money in the US mutual fund.

Conclusions

As a general rule, you should strictly avoid investing directly in PFICs or mutual funds. If you are adventures, then only you should look into investing in individual stocks with your PIS/Trading/Demat account. But again, some companies can be classified as PFICs. So, you will need do your own research before your invest in individual stocks.

If you really want to invest in India, then you should invest in a U.S. mutual fund that invests directly in India as a small portion of your overall US portfolio. I used own WisdomTree India Earnings Fund (EPI), but no longer own it now.

You should also consider investing in an emerging market fund (VEIEX) as a small portion of your overall portfolio in the US. This fund invests in over 900 companies in over 20 countries. This fund specifically holds about 7.5% of its investments in Indian companies, which may not seem high, but it provides full diversification by investing small in lots of emerging market countries.

My other recommendation is to deposit your money in NRE Term Deposits which are currently yielding 9% or above on average. NRE Accounts are not taxed in India. You will be taxed in the US at the usual marginal tax rate depending on your income.