Taxation of Indian mutual funds on US tax return : PFIC Form 8621

Taxation of Indian mutual funds on US tax return is a very critical component of your US tax return.

If you are a US citizen, resident or a green card holder having investment in Indian mutual funds, PFIC reporting is something you just cannot afford to miss. Foreign mutual funds fall under the category of Passive Foreign Investment Company (PFIC) and must be reported on your income tax return in Form 8621. Form 8621 basically seeks to tax any notional, undistributed gains on your foreign mutual funds. What happens when you invest in US mutual funds?

When you invest in US mutual funds, the fund’s annual gains from sale of its holdings are required to be distributed to the unit holders. They are taxed in the hands of the investor as ‘capital gains distributions’ and taxed at par with long term capital gains. Many investors choose to reinvest these distributions in the fund.

However, foreign mutual funds may not follow the same process of distribution. Therefore, PFIC rules were introduced by the Internal Revenue Service (IRS) in order to discourage the practice by US citizens and residents of parking money in offshore tax havens and deferring the US tax liability. For example, a US citizen may invest in mutual funds in India. India does not require its funds to make distributions to its investors and therefore there is no tax on an annual basis. The tax liability would only arise at the time of sale. Thus, in this way, he could defer his US tax liability till the time of actual sale. So while the intent of the PFIC rules was to plug such incidents, most of the Indian mutual funds, being of similar structure, also fall under this category. Let us now understand how should you comply with these requirements.

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 difference between fair market value of each fund on Dec 31st and the adjusted basis in these funds.

Here is how to use the mark to market method:

In the year of purchase, the difference between market value at the end of the year and cost of purchase is taxed as ordinary income.

In 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 at the beginning of the year adjusted for any dividend distributions, additional purchases and sales. In case there is a loss in a particular year, this loss can be set off only to the extent of previously taxed gains. So, for instance, if in year 1, the fair market value increases by $100, your PFIC income would be $100 in year 1. Suppose your loss in year 2 was $150. In year 2, you would be allowed to deduct a loss only up to of $100 from your total income (loss to the extent of gains taxed earlier).

When the units are actually sold, the balance will be taxed as PFIC income. If the price of the fund falls below the cost basis, the loss can be claimed as a capital loss on Schedule D.

Option 2: Election to treat as QEF – Qualified Electing Fund

For most investors, QEF is the most favorable method of taxation. This QEF election allows the taxpayer to distinguish between capital gain and ordinary income of the PFIC. However, in order for the QEF election to be effective, the PFIC must provide the taxpayer with a“PFIC Annual Information Statement” setting forth sufficient information to enable the taxpayer to accurately determine the taxpayer’s pro rata share of the PFIC’s ordinary income and capital gain for the taxable year. Since foreign mutual funds do not keep U.S. books and tax records and provide U.S. tax information to their shareholders, it is almost impossible for shareholders of publicly traded mutual funds to follow the QEF method. 

Option 3: Excessive distribution method

In case the tax payer does not exercise the mark to market option in the first year of purchase, he will be taxed under the excess distribution method described in Code Section 1291. This is the default method. 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 at the highest ordinary income rate (yes, you heard that correctly) and interest at the underpayment rate as determined under Code Section 6621 as if the tax was due at the conclusion of each holding period year. To make matters worse, if there is a loss on disposition, it cannot be claimed as a deduction or capital loss. You will have to fill up part IV of Form 8621.

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