Many US NRIs have plans of returning back to India and thus wish to invest a good chunk of their money in Indian mutual funds. There might also be a case where a resident Indian who has invested a good part of his portfolio in India actually goes to USA on say an H1B and becomes a USC/resident alien in due course of time. After USA enacted FATCA in 2010, since a past few years, almost all of the mutual funds in India have consciously decided not to accept money from US NRI’s in view of the compulsory registration & reporting requirements to IRS on these accounts as well as certain SEC requirements. Quite a few US NRIs I interact with as part of my professional work are blissfully ignorant on the draconian PFIC rules and today, let me discuss these and more in this article.
PFIC: Broad Overview & Why it is so important now?
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. 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.
Now, if you actually think it is very easy to find out whether a mutual fund or an insurance company in India is PFIC or not, think again. Because I looked up Section 1297 for definition of passive income, which in turn refers to Section 954 for foreign personal holding income, and trust me, these sections have very complicatedly defined an institution as PFIC.
The broad indication that I’ve got is that any company deriving any foreign income (no threshold) from interest, dividend, rent, royalties will get qualified as a PFIC. So, your Indian mutual fund will definitely qualify as a PFIC. But then again there is a question on what about individual stocks? – because a company say Infosys will definitely have its treasury and will be earning dividend & interest income from its investments – so will that qualify it as a PFIC? And if it does, then all direct equity investments will also come into the purview of PFIC. This needs a detailed review and I will post my updated learning on it as I move forward. Also refer a table later in the article on what qualifies and what not.
Who is required to comply with the PFIC rules?
As per the IRS Instructions, U.S. person that is a direct or indirect shareholder of a PFIC must file Form 8621 for each tax year under the following five circumstances if the U.S. person:
- 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)
Two points to note here:
- Only US persons (meaning US citizens, Green Card holders, Resident Aliens and spouse of any of these persons who elects to be qualified as a resident) need to comply with this requirement). So, if you were residing in USA and have come back to India and have not taken US citizenship/Green Card, you are spared.
- The requirement arises if you as a US person hold a single $ in investments that qualify as PFIC, regardless of whether there is any realised income/capital gain from those investments.
How PFIC investments are taxed to US persons
The taxation of PFIC investments is harsh to say the least. While capital gains from US based mutual funds carry an impose a lower rate of 15% long term capital gain (if units are held for > 36 months), the major difference in case of PFIC investment is that even an unrealised gain needs to be offered as income and is taxed at the highest individual rate. Of course, this is not the standard treatment and it depends on which election you’ve opted for the investment.
Any person investing in PFIC has to make an “election” for the investment to be treated in one of the following ways, when he reports the same in Form 8621 (will come to this later in the article)
#1: As a 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. This is not a practical option and if you disagree, ask any Indian Mutual fund to give this info to youJ
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
This option can only be exercised if the PFIC stock is a “marketable stock”. For e.g. Indian MFs by legal obligation have to declare an NAV on a daily basis, hence will fulfil this requirement. ULIP policies can also fall in this election, but what about traditional policies? So, there are certain grey areas as to which PFICs will qualify for this election.
Once you make this election in Form 8621, the US person is 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.
#3: Excess distribution method:
This is the default option if you’ve not exercised one of the earlier two options. 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!
Reporting requirements under PFIC rules
Instructions on filing Form 8621 (PDF)
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 reporting requirement which has a threshold of $300000 for US persons living abroad and $50000 for those living in the USA.
- 8621 reporting is applicable even if there is no obligation to file a return under the IRS tax code.
Common questions on PFIC
Below are answers to some of the common questions on PFICs:
#1: Which Indian financial products may qualify as PFIC?
I have tried to explain in the table below. However, I have just expressed my opinion here (and it may be wrong also!). Since the rules are too complicated, decision on whether an investment qualifies as PFIC requires a thoughtful and detailed analysis.
| Product | Qualify as PFIC? |
| Unit of a mutual fund | Yes |
| Equity Shares | Yes (in some cases) |
| Investment cum Insurance Policies (e.g. ULIP, traditional plans) | Yes |
| Bank savings accounts & fixed deposits (e.g. NRE FDs) | No |
| Exchange Traded Funds | Yes |
| Direct purchase of bonds, debentures etc. | No |
| Tax Free Bonds purchased from primary/secondary market | No |
| Fixed Maturity Plans (FMP) by mutual funds | Yes |
#2: Can I invest in wife’s name who is NOT a US citizen?
If your spouse elects to be treated as US resident in your tax return, she will qualify as US person for purpose of these regulations. If not, if she is living with you in US, most likely she will be a US resident alien and hence will fall in purview of the regulation. In a rare case of your spouse living in India, you can gift her the money which she can invest – however, do take care of the IRS lifetime exclusion limit for gifts and Indian tax rules on clubbing of income: ideally, she should invest that money only in equity mutual funds and hold it for a period of more than 1 year, to qualify for returns to be tax free and not clubbed in your income as per Indian tax rules. However, also ensure proper documentation in form of a gift deed before making such a transaction. Indian tax authorities may want to check the source of funds in case her case gets picked up for scrutiny.
#3: What if I’ve made these investments before becoming a US person?
Unfortunately, even in such a situation, there is no respite. As soon as you become a US citizen, the adjusted basis for the investments will be the fair market value as on Jan 1 of the tax year in which you became resident.
Additional reading:
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