The IRS mandates that the citizens and residents of the United States need to pay taxes on all their global income. Thus, if you are a US permanent resident or a citizen and are investing in Indian or any other foreign mutual funds, then you need to self-report and pay the long-term capital gains tax on your holdings on an annual basis while filing your US tax returns. Else, you will run foul off the Foreign Account Tax Compliance Act (FATCA), which makes it mandatory to report Passive Foreign Investment Companies (PFIC), and could face some really harsh penalties.
In the US, foreign mutual funds are categorized under PFIC. The IRS (Internal Revenue Services) notably introduced PFIC rules to make sure that the US residents and citizens don’t invest their money offshore to defer the US tax liability. Under PFIC, if a US citizen parks his money in a property or mutual funds in India, he is not taxed annually in India. While selling the investment, the capital gain will be tax-free in India, but he will still have to pay taxes according to the US tax code on his global income.
The kicker here is that the US treats the revenue generated from the periodic distribution from mutual funds such as capital gains and dividends or interest on an annual basis as ordinary income, which is taxed at a much higher rate as compared to long-term capital gains. This is done to encourage US citizens and residents to keep their investments in the US rather than offshore.
There are three essential caveats you need to keep in mind if you are a US resident or citizen, who resides in the US but who decides to invest in mutual funds in India:
- Fill in IRS Form 8938 if your financial assets abroad exceed the threshold of $50,000
- Check the box which reads, “Passive Foreign Investment Companies” in the same form
- File Form 8621 every year, for each PFIC
Follow these steps and you will be self-reporting your mutual fund investments abroad, India or anywhere else, to the US tax authorities. This will prevent you from being prosecuted for tax fraud.
If your mutual funds belong to an Indian mutual fund company, the Form 8621 allows you a bunch of options to declare notional appreciation.
Option 1- Election to mark-to-market PFIC
Election to mark-to-market is one of the preferable options for Indian mutual fund investment. The annual notional gains on the market value of your investments need to be declared as ordinary income.
In the year of purchase: The difference between the cost of procurement and the market value at the end of the year implies the gains.
In subsequent years: The difference between the market value annually and “adjusted basis” at the implies the gains. The market value of the shares at the beginning of the year is usually the adjusted basis. In case of losses, only the previous year’s loss can be set off against the Foreign PFIC notional gains.
Once you sell your mutual fund units, you will be liable to pay tax on the long term capital gains only on that portion of your total gains, which has not been taxed as ordinary income in the preceding years.
Option 2: Election to treat as Qualified Electing Fund -QEF
In the case of Qualified Electing Fund, all of the investors act as partners and equally share the fund profits. This option is only valid if the foreign fund has the policy to share the profits information with the investors.
Option 3: Excessive distribution method
This option is used by default. If you do not use either of the above two options, the government will charge you according to the excessive distribution method, easily the most expensive option on the list.
Here, the current year’s distributions should match at least 125% of the last three years average distribution. If this condition isn’t met, you will be taxed the highest rate of tax that particular year along with interest on every year’s tax liability.
Filing taxes can be a complicated and a vexing exercise, especially when you need to traverse through complex IRS wordings. Not being compliant with the tax regulatory requirements can land you in a lot of hot soup, especially if you fail to report your PFIC in an orderly and timely fashion even unwittingly. It’s best to take the help of experienced tax preparers like MyTaxFiler to ensure you stay on the right side of the law.
For more such tax news and updates, stay tuned with MyTaxFiler. We also provide a one-stop solution for all your tax-related woes. Simply drop a mail at email@example.com or call us at (888)-482–0279 for an on-call consultation.