Last updated on – Nov 7, 2024
US has a draconian tax provision for Passive Foreign Investment Corporation (PFIC) which makes it unwise for a US person (Citizen/GC/Resident) to invest in any non-US pooled investments. Lot of non-US persons who are unaware of these rules end up moving to US & getting trapped in these regulations whereby they cannot sell their holdings for the entire duration of their US residency or if they sell, there are hefty tax & reporting complications that arise.
Basically, PFIC is US’s way of disincentivising US persons from investing outside of the US. The underlying presumption (often incorrect in case of expats from other countries) is that if a US person invests outside of the US, it is to evade the US tax.
Common scenarios where Indian expats hold PFIC type investments
I’ve seen Indian expats holding PFIC type Indian investments in following cases-
Scenario 1 – Person moves to US on H1B visa & has Indian pooled investments in his portfolio & doesn’t sell them as she is not aware of the PFIC implications in US.
Scenario 2 – Expat is based in US (US resident) & has long term plans of returning back to India and thus wish to invest a good chunk of her money in Indian pooled investments mutual funds & ETFs etc so that she gets benefit of professional management of her money & money is in INR so it is protected from exchange risk.
Scenario 3 – Expat has returned back to India after a stint in US wherein the person has got a USC/GC in due course of time and buys Indian pooled investments.
PFIC: So what is the problem with it?
The US government, in a bid to disincentivise US persons from stashing their money in foreign jurisdictions, made a rule whereby any money in a passive foreign investment company (PFIC) will attract a tax every year on even the unrealised portion of gain, at the maximum marginal rate applicable to individuals (generally, 37%). Further, it has prescribed reporting requirements in such a case.
Earlier, US NRIs could still get away with non-compliance with this requirement but FATCA has changed everything. With financial institutions in Indian holding accounts of NRIs under obligation to report those to the IRS, it can easily cross check to see whether the person has complied with PFIC rules or not. So, as an NRI, if you have even a single rupee invested back in India, it makes a lot of sense to read and understand the implications of these rules for your finances.
Who qualifies as a PFIC?
Very few US NRIs are aware that IRS treats the holdings in passive investment vehicles in foreign countries as “Passive Foreign Investment Companies” (PFIC) and treats them differently for tax purposes as compared to a US based mutual fund investment. As per the IRS definition of 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 (as defined in section 1297(b)).
- Asset test: At least 50% of the average percentage of assets (determined under section 1297(e)) 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.
Which Indian investments may qualify as PFIC?
If you go about the above tests, any Indian investment which has a significant passive earnings component & which pass the above tests will qualify as a PFIC for US purposes. Given the punitive implications, it’s always advisable to err on the side of caution in deciding whether an investment qualifies as a PFIC or not.
As per my limited understanding, I’ve created a breakup of Indian investments for classification purposes as below:
- Qualify as PFIC – Indian mutual fund, ETF, REIT, INVIT, ULIP, Traditional Insurance Plans with cash value component, NPS, closely held investment/holding type companies earning mainly passive income
- Not qualify as PFIC – Shares & Bonds of companies having active business, Bank Savings Account balances, FD, Gold in physical or bond form, PMS (may not qualify if holding within the PMS is non-PFIC type investments only)
Now that we are settled on what constitutes a PFIC
A US person having any of the following needs to comply-
- Direct or indirect shareholder of a PFIC
- Receives certain direct or indirect distributions from a PFIC
- Recognizes gain on a direct or indirect disposition of PFIC stock
- Is reporting information with respect to a QEF or section 1296 mark-to-market election,
- Is making an election reportable in Part II of the form, or
- Is required to file an annual report pursuant to section 1298(f)
- Has any direct or indirect interest in any PFIC entity
Two points to note here:
- Only US persons (meaning US citizens, Green Card holders, Resident Aliens) need to comply with this requirement). So, if you have returned from US & not a US person, you’re saved & escape the clutches of PFIC.
- There is no threshold – The requirement applies even if you hold a hold a single $ in investments that qualify as PFIC, regardless of whether there is any realised income/capital gain from those investments.
Tax & Reporting Implications for PFIC
Once you’re clear that PFIC applies to you, basically there are 2 implications – reporting & tax liability. Let’s discuss both in detail.
Reporting
You need to file a separate report in Form 8621 per scheme per year along with the tax return.
Note that many online providers like TurboTax etc. don’t support this form, so you’ll have to be careful to select the right online provider who supports this form.
If you go with a CPA, make sure she is aware about PFIC reporting & tax calculations if applicable. Many clients have reported to me that their CPAs were not even aware of these provisions. Also, some CPAs, as they work on a fixed fee per return, even if they know the rules. they don’t want to take this additional burden which takes up a good amount of time & effort especially if you have multiple such investments. So better to enquire about the knowledge & 8621 filing fee upfront.
Taxation
The taxation of PFIC investments is highly complicated and depends on the type of election you make for the fund. While a capital gains tax applies at 0,15 or 20% rate in US on long term “realised” capital gain, in case of PFIC, depending on type of election, the “unrealised” capital gain can be taxed at “ordinary income” & that too, at a maximum marginal rate of 37%!!
Any person investing in PFIC has to make one of the following elections for the investment when she reports the same in Form 8621.
#1: Qualified Elected Fund (Also known as a Section 1295 election):
This is the most tax efficient (or I will say the least tax inefficient) methods. If you elect your PFIC as a Qualified Elected Fund (QEF), it requires you to disclose your prorate share in the earnings of the PFIC in the Form 8621. Further, PFIC is required to provide you an Annual Information Statement disclosing your pro-rata earnings and other sufficient information for calculation purposes. Note that QEF option is available only if you are a direct or indirect “shareholder” in the PFIC. This is not the case in case of Indian MF/ETF where the person is a unitholder & not a shareholder in the financial institution. Also, most public financial institutions do not release the necessary information to make this election. This election is most suitable for most closely held corporations where you are a shareholder.
Tax treatment of QEF is that shareholder of a QEF must annually include in gross income as ordinary income its pro rata share of the ordinary earnings and as long-term capital gain its pro rata share of the net capital gain of the QEF. Also, there is an option in Form 8621 to extend the time to pay tax until QEF election is terminated.
#2: Mark to Market Election (Also known as a Section 1296 election):
This election can only be made if the stock of PFIC is a “marketable stock”. Marketable stock is further defined as a stock which is traded on a recognised stock exchange. So, this election may be possible for say an Indian ETF or a InvIT which is listed on National Stock Exchange in India but it won’t work for say a mutual fund as it is not listed on a recognised stock exchange in India. However, since this option is favourable to option 3, as a general practice it is used by some CPAs to even report for Indian MF which in my view (& limited knowledge) is not correct.
Once you make this election in Form 8621, you are required to disclose the excess of the fair market value of the investment at the close of the tax year vis a vis the value at the start of the year and it is taxed as “ordinary income”. This is irrespective of whether this excess was “realised”: this means, even if you’ve not sold the asset during the year, you still need to pay tax.
This election causes a FTC mismatch issue – Since tax is paid in US on unrealised gain in a particular year & stock is not actually sold in India, you cannot claim any tax credit in US. In a later year when you sell the stock in India, you won’t be able to claim credit of US tax as it was paid in earlier years & not in the Indian sale year.
#3: Excess distribution method (Section 1291 fund)
This is the default election if you’ve not made the earlier two elections. Under this election, you are subject to special rules when they receive an excess distribution, or recognize gain on the sale or disposition of the stock of, a section 1291 fund. A distribution may be partly or wholly an excess distribution. The entire amount of gain from the disposition of a section 1291 fund is treated as an excess distribution.
Excess distribution has been separately defined as the part of the distribution received from a section 1291 fund in the current tax year that is greater than 125% of the average distributions received in respect of such stock by the shareholder during the 3 preceding tax years.
One relaxation available is that no part of a distribution received during the first tax year of the shareholder’s holding period of the stock will be treated as an excess distribution. This generates a planning window of someone who has moved recently to the US & has PFIC type investments back in India (read strategies section below).
As per the IRS instructions, an excess distribution is the part of the distribution received from a fund in the current tax year that is greater than 125% of the average distributions received in respect of such stock by the shareholder during the 3 preceding tax years. Now, on selling the asset, the tax liability on the gain will be spread into all the years in which the asset was held and taxed as ordinary income. Also, there will be an interest levied on the delayed tax payment. So, for e.g. you invested $100 in a mutual fund in 2006 and now selling in 2016 for $200. So, $10 will be included in taxable income of each year and you’ll have to pay a combined tax on it, at the time of sale. Also, you will be required to also pay interest for the delayed payment. So, simply put, this is as worst as it can get!
Important points to note regarding the reporting requirement is as follows:
- There is NO asset level threshold for reporting – if you own even a 0.000001% holding in a PFIC, you need to report it to the IRS.
- 8621 reporting requirement is independent of the 8938 & FBAR reporting (FATCA) requirements which have their own separate thresholds.
- 8621 reporting is applicable even if there is no obligation to file a tax return under the IRS tax code.In such case the form has to be paper filed to the IRS.
Strategies for Indian expats holding PFIC investments
Below are some of the strategies I would recommend/suggest. Please consult your CPA before implementing any of them.
If you’re planning to move to US, examine your investment portfolio for any PFIC type investments. To the extent possible, close those investments in India before moving to US. Do not mind some tax implication in India (it’ll be much less than the PFIC tax implication in US).
If you wish to remain invested in India, you can buy non-PFIC investments however I would recommend to take the money in the account & move it to US & invest there (you can move up to 1 Mn USD from India to US in a financial year) & stay invested in US for major portion of your investments for the duration of your US residency.
Gifting to close relatives before moving to US is a strategy people use – I don’t entirely support it as the real nature of the transaction is not a gift but to evade US tax & later on it can be questioned especially if the funds are reverse-gifted & remitted back outside India. (low possibility, but it exists). If you do gift, on a cautionary note – ensure there is some documentation around intention to give & receive the gift/gift deed (if amount significant) is in place to document the nature of transaction, ensure parent/close relative files tax return every year & discloses gift in year o receipt in Schedule EI – Exempt Income.
If you’ve already moved to US or have become a USC/GC & hold PFICs, you may be exempted from tax/reporting requirements if the value of PFIC investments is less than $25K (if Married Filing Single)/$50K (if Married Filing Joint) & investment is under Growth plan – if this be the case, ensure that you do not sell the investments for the entire duration of US residency. The law is unclear on this exemption, so please double check with your CPA. Also there is always a risk of proposed regulation (discussed above) being put into action which can cause an unpleasant tax consequence for you at the time of leaving US residency. The IRS instructions read as follows –
Exception if aggregate value of shareholder’s PFIC stock is $25,000 or less. A shareholder is not required to complete Part I with respect to a specific section 1291 fund if the shareholder meets the $25,000 exception on the last day of the shareholder’s tax year and the shareholder does not receive an excess distribution from, or recognize gain on the sale or disposition of the stock of, the section 1291 fund. For purposes of determining whether a shareholder satisfies the $25,000 threshold, the shareholder takes into account all PFIC stock (QEFs, section 1291 funds, and PFIC stock subject to a section 1296 mark-to-market election) owned directly or indirectly other than PFIC stock owned through another U.S. person or PFIC stock owned through another PFIC. Shareholders filing a joint return have a combined threshold of $50,000 instead of $25,000 for purposes of this exception
There’s another relaxation available whereby you can dispose of the holdings in the first year of your holding a Section 1291 fund them without the gains being considered as excess distribution from the point of view of PFIC regulations. So, if you have a mutual fund holding which has not completed one year & you are a US person, you can straightaway sell those holdings. In such case, the more favourable normal capital gains provisions in US tax law should apply to those gains rather than the 1291 tax consequences so one can plan accordingly.
If you’ve already moved to US or have become a USC/GC & hold PFICs in value greater than $25k/$50K, there’s no option but to report in Form 8621 per scheme along with tax return. The statute of limitation for the tax return does not start till you file this return & the return is considered incomplete without this form. If you’ve already filed the return. You can generally amend the return generally going back 3 years from date of original return/2 years after date of paying tax whichever is later. You can take benefit of the amended return filing window & file amended returns.
If you’re not sure of your stay years in US going forward or expecting a GC/USC – I would suggest to evaluate the option of selling off all PFIC holdings in India in a year – this will involve a one-time financial & compliance cost hit but save you from filing multiple Form 8621s every year for the rest of your US residency (or rest of your life if you get a USC/GC). Remember, the more you continue with the PFIC, the more the tax impact will build up and bite you in a later year. Better to cleanse your portfolio of PFIC taint as early as possible.
Beware of Indian agents & product sellers/distributors selling you PFIC products in the guise of “India growth story”
but not telling you transparently the applicable PFIC implications & its punitive implications because they very well know that if you know the tax consequences, you won’t invest & that’s not good for their business. This in my view is unethical business practice & as the rule goes, buyer needs to beware. If you want to invest in India growth story, no one is stopping you to invest in India focussed ETFs in US like FLIN or others in that category– they don’t qualify as PFIC & you also get India exposure in your portfolio. If you still wish to invest in India, you can consider directly investing in non-PFIC investments. If you want to invest in India AND want a professional managing your funds, you can consider PMS or family office type structures however you need to give them specific instructions that your portfolio should stand in your name & not invested in any PFIC-type investments. PMS investing has its own pros & cons which are out of scope of the article.
Hope the post was useful. Do share feedback in comments.
References –
Instructions on filing Form 8621 (PDF)
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