Mutual funds in India maybe a great investment avenue.
Dividends are tax free; long term capital gains on equity funds are also tax
free. And if you have been a long term investor, chances are, you built a
fairly good corpus thanks to the robust Indian equity market. But if you are an
Indian American, Uncle Sam is going to want a share of your pie. That's because
the US tax code collects tax on the global income of its residents and
citizens. What is more peculiar is that tax is levied on global income as per
the rules that apply to that kind of income in the US. Foreign mutual funds in
particular face this peculiarity.
First let us quickly look at the tax rules that apply for US mutual funds. In
the US, a mutual fund's annual gains from sale of its holdings must be
distributed to the unit holders and taxed in the hands of the investor as
'capital gains distributions' and these distributions are taxed at par with
long term capital gains. Many investors choose to reinvest these distributions
in the fund.
Foreign mutual funds in the US fall under the category of Passive
Foreign Investment Company (PFIC). Vinay Navani, CPA and director of tax at
New Jersey based firm Wilkin & Guttenplan, P.C, gives a background,
"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 instance, a US citizen might put his money in an investment
company or mutual fund situated in the Cayman Islands. Cayman Islands does not
require its funds to make distributions to its investors and therefore there is
no tax on annual basis. At the time of sale, while capital appreciation would
be tax free in the Cayman Islands, the US citizen/resident would still have to
pay tax in the US since he is taxed on his global income. By doing this, 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, foreign mutual funds, being of similar structure,
also fall under this category. Broadly speaking, according to the PFIC rules,
the citizen will face some harsh tax consequences unless he chooses one of the
options described below."
While we will get into the details of the options next, it is important to
understand that in option 1 and 2, the PFIC rules essentially seek to tax
notional gains arising from PFIC investments. These gains are taxed as ordinary
income. Option 3 is when the taxpayer chooses to do nothing and pays interest
and penalty.
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. Navani
explains, "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 1. 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
Now there may be a case where you purchased units of the fund before you became
a US resident or citizen. In such case, in the first year of your tax returns,
the value of your PFIC income will be the appreciation in market value of the
fund holdings during the tax year.
Navani illustrates, "X, a nonresident of the US, buys
marketable stock in a PFIC for $50 in '95. On Jan. 1, 2005, X becomes a US
resident. The fair market value of the stock on Jan. 1, 2005, is $100. The fair
market value of the stock on Dec. 31, 2005, is $110. X computes the amount of
mark-to- market gain or loss in 2005 using a $100 adjusted basis. Therefore, X
includes $10 in gross income as mark- to-market gain and increases its adjusted
basis in the stock to $110. X sells the stock in 2006 for $120. X must use its
original basis of $50 plus the $10 mark-to-market basis adjustment. Therefore X
recognizes $60 of gain, of which $10 would be ordinary income and $50 long-term
capital gain."
Maryland based tax attorney and Principal at Kundra & Associates, Chaya
Kundra also adds, "For the recent resident, it is often best to elect
mark-to-market upon the filing of the first year of their return for the most
favorable tax treatment."
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," Navani says.
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," says Navani.
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.
A common query then: If you are an NRI and will be in the
US on a project for 2-3 years and you know for certain that you will not sell
your Indian mutual funds during that time period, does it make sense to go for
the default option? This is a tricky one. While this strategy may work for now,
a proposed amendment to PFIC rules could prove a dampener.
Kundra explains, "According to this proposed amendment, if a US citizen or
resident owning PFIC stock renounces citizenship or abandons US residency,
thereby becoming a nonresident alien for US tax purposes, the individual is deemed
to sell the PFIC stock on the last day that he or she is a US person."
She adds, "This is a proposal and not yet a law. Having said that, from
the IRS website,
proposed regulations are often used as precedents by the IRS. It is important
to note that this will more than likely become law and when it does, it will
apply retroactively."
Form 8938 and Form 8621
From this tax year onward, the IRS has introduced a new Form 8938 for reporting
offshore bank and financial accounts. "Be careful with the new Form
8938," Navani advices, "In Form 8938, in Part IV, you must check that
you have filled up Form 8621. If you inadvertently declare holdings in Indian
mutual funds in your Form 8938, the IRS would automatically check for Form
8621. Consult your CPA or tax advisor."
These are just the broad modalities of how PFICs are taxed. Several adjustments
may occur in individual situations. Consult your CPA or tax advisor to choose
the best election and arrive at appropriate values.
Source: http://economictimes.indiatimes.com/news/nri/nri-investments/how-nris-india-mutual-funds-are-taxed-in-us/articleshow/12881470.cms?curpg=2
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