Lots of U.S.NRI investors invests in
(non-US) mutual funds, bonds and various types of “life insurance” products
(the latter are often a fancy version of a foreign mutual fund
investment). Sadly, these investors are often taken in by the sales pitch
of investment advisors unfamiliar with latest India tax laws. The sales pitch
focuses on the fact that the investment can grow tax- free for many years.
While it is true that no tax may be payable in the fund’s jurisdiction (Nil
Long term capital gain for Equity for instance), significant US taxes are
payable by the US NRI's owner under the so-called “passive foreign investment
company” or “PFIC” rules. US
The latest IRS announcement regarding the annual reporting of PFICs as mandated by tax laws enacted in President Obama’s first term. The Foreign Account Tax Compliance Act (FATCA) enacted in 2010 had numerous provisions. One of them mandated that US owners of PFICs (whether such ownership is direct or indirect) must annually report significant information to the IRS(Internal Revenue Service U.S). This annual report was to be made on Form 8621.
What is a PFIC and What Does it Mean If you Have One?
More often than not, the foreign mutual fund or similar investment will be characterized as a PFIC. A PFIC includes any non-US corporation if 75% or more of its gross income for the year consists of “passive income”. Passive income generally includes dividends, interest, rents, royalties, most foreign currency and commodity gains, and capital gains from assets that produce such income. Just about all of the income of a fund will usually qualify as passive and so, nearly all foreign funds will qualify as PFICs!
Don’t Mind Losing Your Investment? PFIC Means Very Harsh Tax Consequences
Form 8621-This is the form you would need to fill up if you have mutual fund holdings in an Indian mutual fund company. The form gives you several options to declare the notional appreciation. Let's take a look at the options relevant for a retail mutual fund investor:
Option 1: Election to mark-to-market PFIC
This is the most common option for Indian mutual fund investments. "Broadly speaking, according to this option, you must declare as income the notional gains in the market value of your fund holdings during the year."
Here is what typically happens:
- In the year of purchase, the gains are the difference between market value at the end of the year and cost of purchase.
- In the subsequent years, the gains are the difference between market value at the end of the year and 'adjusted basis'. Adjusted basis is usually the market value in the beginning of the year. In case there is a loss, the loss can be set off against foreign PFIC notional gains of only the previous years. Any loss that is not set off is added back to the adjusted basis of the next year. So for instance, if in year 1 you incurred a notional gain of $100 on your PFIC, $100 would be taxed as ordinary income in year
Suppose your loss in year 2 was $150. In year 2, you would be allowed to deduct a loss of $100 from your total income (loss to the extent of gains taxed earlier).
- When the units are actually sold, you will be taxed long term capital gains only on the portion of gains that has not been taxed in previous years as ordinary income
Option 2: Election to treat as QEF - Qualified Electing Fund
"This option is commonly used in case of investments by US residents and citizens in offshore private equity funds,"
A QEF is taxed like a partnership wherein each investor is considered to have a share in the total profits of the fund. You can exercise this option only if the foreign fund agrees to share information with you about your share of profits.
Option 3: Excessive distribution method
"This is a default election. If you opt out of all other options, you will be taxed as per this option, which is also the most taxing,"
He adds, "According to this option, the distributions in the current year should be
at least 125% of the average distributions of last 3 years. The logic being that you are receiving incremental income every year from the fund and therefore not trying to defer taxes. If you do not meet this condition, then the total distributions are allocated over the entire holding period and taxed in each year at the highest tax rate of that year. Not only that, you will also be charged interest on each year's tax liability."
What this means: Suppose you did not make any election on your PFICs and throughout the holding period, did not fill up Form 8621 for your PFIC holdings.
You held the PFIC units for say 10 years and did not receive any distributions during these 10 years. In the year of sale, you made a gain of $100. In the year of sale, your gains will be distributed over the past 10 years, that is, $10 per year. It will be treated as though you did not pay tax on $10 per year and hence in year 10, you must pay tax for each of these years plus interest on the delay. You will have to fill up part IV of Form 8621.
Just in case you are thinking of ‘ignoring’ the rules regarding self-reporting on PFICs, please note that under other provisions of FATCA, ”foreign financial institutions” will be required to report directly to the IRS about assets held by US persons with that institution. The FATCA rules will make it very easy for the IRS to cross-reference the information provided by the foreign financial institution with the taxpayer’s Form 8621 to determine whether taxes and reporting on the foreign fund have been properly undertaken.