How NRIs’ India mutual funds are taxed in US

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

AMFI lobbies with FM for mandate to run RGES over ELSS

Association of Mutual Funds (AMFI) in India is lobbying with the finance ministry to secure an exclusive mandate to implement the Rajiv Gandhi Equity Scheme (RGES), a tax-efficient investment plan for retail investors that was introduced in the Union Budget.

A permission to allow the domestic mutual funds to handle the proposed equity scheme will help the industry replace its existing tax-saver product - equity-linked savings scheme - which will lose its tax-saver status under the Direct Taxes Code regime. The mutual fund industry body, which represents 44 Indian asset management companies, is making the pitch for executing the RGES as it caters to small retail investors who are investing in the markets for the first time.

Source: http://www.moneycontrol.com/news/mf-news/amfi-lobbiesfm-for-mandate-to-run-rges-over-elss_697174.html

Fidelity MF sees Rs. 805 cr outflow ahead of sale completion

The acquisition valued Fidelity MF at 6.2% of its average assets under management (AUM) of Rs. 8,881 crore for the quarter ended December

Investors are pulling out from Fidelity’s Indian mutual fund (MF) schemes. In the March quarter, investors in the equity schemes of FIL Fund Management Pvt. Ltd withdrew at least Rs. 805 crore, while the Fidelity group was conducting a strategic review of its Indian MF business that ultimately led to the sale of the fund.

Fidelity MF announced the sale of its assets to L&T Finance Ltd for an undisclosed sum in the last week of March. A person with direct knowledge of the matter said the deal was clinched at around Rs. 550 crore. Fidelity and L&T Finance had declined to comment on this figure at the time.

The acquisition valued Fidelity MF at 6.2% of its average assets under management (AUM) of Rs. 8,881 crore for the quarter ended December.

According to data available with registrars and the capital market regulator, the average AUM of Fidelity MF’s five equity schemes grew by an average Rs. 73 crore to Rs. 5,698 crore in the March quarter from the December quarter .

The 50-stock Nifty index of the National Stock Exchange grew 14.52% between January and March, while the 30-share benchmark Sensex of BSE went up 12.61%. In line with this, the net asset values (NAVs) of the five schemes of Fidelity MF grew 13.16-20.32%.

Going by the returns these schemes offered to investors or their NAVs, a back-of-the-envelope calculation shows that the average assets of the five equity schemes should have grown by Rs. 877.99 crore and not Rs. 73 crore. This means, these schemes witnessed an outflow of Rs. 805 crore.

Most fund houses during the quarter saw a net inflow of money into equity schemes.

Fidelity had six equity schemes, but five have been considered for calculations as they contribute the bulk to the AUM. They are Fidelity Equity, Fidelity India Growth, Fidelity India Special Situations, Fidelity Tax Advantage and Fidelity India Value.

The figures are also available with the Association of Mutual Funds in India (Amfi), an industry lobby.

A Fidelity MF spokesperson rejected the contention that there had been an outflow to the extent calculated by Mint.

“We are not seeing much outflow and have not seen a net outflow of anywhere even close to Rs. 800 crore in the five equity schemes of Fidelity Mutual Fund during the January-March 2012 period. Therefore, it would be absolutely incorrect and wrong if any such story is carried,” the spokesperson said.

A senior Fidelity group official said, “In January, after informing Sebi (Securities and Exchange Board of India) about our business plan, we informed our investors, as per the rule, that they could redeem their investments in fixed-maturity plans, or FMPs, as they could not be rolled over. This news may have led to an exit of investors.”

The outflow from equity schemes flags the critical issue of protecting the assets of a fund house that is on the block. The price paid by L&T Finance to acquire the assets of Fidelity MF was based on the size of the equity schemes, but by the time the deal is consummated, the size of the schemes may shrink, distorting the valuation. The deal has not closed yet.

Outflows from Fidelity MF schemes are happening before the so-called free-exit period. Once Sebi approves an acquisition, investors in the selling fund house are given a month’s time to withdraw their investments.

L&T Investment Management Ltd, a subsidiary of L&T Finance, is in the process of securing Sebi approval for the acquisition. L&T MF currently manages average assets worth Rs. 3,897.6 crore.

Following the deal, L&T Finance had said that the combined entity will have a market share of 2% in terms of AUM. But if the erosion of assets continues, that may not happen.

An industry expert, who did not want to be named, pointed out that in case of a merger between two banks, the banking regulator typically imposes a moratorium and freezes operations of the bank that is being absorbed. This is to protect deposit liabilities and advances.

Fund house acquisitions are valued on the basis of the asset mix, network strength, long-term earnings prospects and profitability. There have been several acquisitions of Indian MFs at valuations ranging from 1.6% to 13% of AUM.

There are 44 fund houses with total average AUM of Rs. .64 trillion in the March quarter.

Fidelity MF had a team of seven people to manage its equity schemes.

“Fidelity MF investors had certain trust on its fund managers built over years. L&T doesn’t have much experience in mutual fund management and unless they create a trust among investors, it will be a challenge to retain the investors,” said the CEO of foreign MF who declined to be named.

Source: http://www.livemint.com/2012/04/26000423/Fidelity-MF-sees-Rs-805-cr-out.html

Retail investors switch to safer, low-risk MF options in hard times

Despite volatile markets, weak sentiments and a faltering growth story, retail investors are not fleeing the market. On the contrary, they are adopting a new strategy to counter the current situation: shifting investment from high risk, high-return equity schemes of mutual funds to low risk, low-return debt schemes of MFs.

The number of folios in equity schemes of mutual funds declined to 37 million at the end of March 2012 from 38 million at the end of March 2011, whereas the number of folios in debt schemes grew to 4.5 million at the end of March 2012 from 3.9 million at the end of March 2011.

“It shows that there are investors who do not rush to open fixed deposit just because there is volatility in the market,” said Arindam Ghosh, vice-president and head, retail sales, JP Morgan Asset Management. “They rather go for less-risky instrument available in the market.”

In last fiscal, when the Sensex went up to 19,100 (in April 2011) and fell to 15,100 (in December 2011), the number of folios (equity and debt schemes) did not see a sharp decline. Total number of folios at the end of March 2012 stood at 42 milliom against 43 million at the end of March 2011.

A mutual fund scheme that invests major portion of its corpus into equity and equity-related instruments is called an equity mutual fund. In debt-oriented schemes the money is invested in bonds and other debt instruments. Since money is invested in debt instruments such as government bonds, corporate bonds, debentures, the returns are comparatively low and carry very low risk.

“In the last one year, when the market was volatile, we did not see any significant surge in redemption from retail investors,” said Lalit Nambiar, senior vice-president and fund manager, head, research, UTI Mutual Fund.

Source: http://www.hindustantimes.com/News-Feed/BusinessBankingInsurance/Retail-investors-switch-to-safer-low-risk-MF-options-in-hard-times/Article1-846150.aspx

Soaring crude oil prices are the biggest risk: Swati Kulkarni

Interview with Fund manager, UTI Mutual Fund

Firm crude oil prices, depreciating rupee and ballooning current account deficit are expected to keep the economic growth rate at around seven per cent for another year, says Swati Kulkarni, fund manager, UTI Mutual Fund in an interview with Priya Kansara Pandya. Edited excerpts:

Where are the Indian markets headed in 2012?
We are positive on Indian markets as the valuation is now comfortable at 13x FY13 earnings, which is close to the historical average. The downside from the current levels seems to be limited. However, in the near-term, we expect range-bound movement.

What are the likely triggers for an upside and what is the probability of that event happening?
Softening of commodity prices, manageable inflation levels and a pick-up in the investment cycle can lead to an upside. It is difficult to predict the probability as a lot depends on crude prices and other global events. However, given the below-normal world economic growth, the demand side support for a structurally high level of crude seems unlikely. We expect crude prices to remain range-bound.

So, that means there will be less pressure on the rupee?
The rupee is under pressure because of the current account deficit and capital flows, which have been volatile. The probability of rupee crossing 54 levels is grim. We expect it to remain between 52-54 levels in the medium-term.

What are key risks to the Indian economy?
The first and the biggest risk, of course, is the price of crude oil. I feel the budgeted estimates for oil subsidies may be inadequate. The second biggest risk we see is weak investment cycle, which has not seen a pick-up for some time now. This could affect consumption and future employment potential, which in turn could affect economic growth. As a result, this will keep our growth at seven per cent for another year or so.

However, I would like to put a caveat here that everything does not look gloomy at this point in time. All these concerns are fine when you are trading at 21-22 times. We are trading at much lower levels.

After raising rates 13 times between March 2010 and October 2011, the Reserve Bank of India (RBI) has not guaranteed further rate cuts after the surprise 50 basis points cut in April. Will it succeed in kickstarting growth?
We should understand that the rate hikes did not happen at one go. So, we should also be patient for rate correction and let it happen over a period of time. RBI cannot take quick steps without addressing the real problems. Currently, the base effect for inflation is expected to be favourable for some time.

But strong consumption, rising crude oil prices and current account deficit can again put pressure. By the end of this calendar year, there is a likelihood of inflation surfacing again due to supply side constraints and structural issues. Further, if fiscal deficit continues to balloon then what is the guarantee that these rate cuts will not lead to further inflation? Certain asset bubbles can be created. Thus, I feel, RBI is going in the right direction. Rather than 25 bps, having a 50 bps rate cut may have a better visible transmission.

Do you expect any more rate cuts going ahead?
We don’t expect that as fiscal correction is necessary. But at least from hereon, I don’t expect interest rates to go up further. They seem to have peaked and that trend is clear.

Which sectors are expected to do well in the coming quarters?
Besides consumption, cement and pharma sectors are expected to do well. However, energy will not do well due to price controls and stressed global petrochemical margins. Also, the engineering sector could remain subdued as order inflow momentum is yet to pick up pace.

What has been your strategy in the past six months and will that continue?
In past six months, we have reduced exposure from rate insensitive sectors like information technology (IT) and shifted to auto and banks assuming that interest rate cycle is peaking out. That would continue. Others, more or less, remain the same.

We had neutral position on consumer. We preferred cement to construction and real estate stocks. However, with likely peaking of interest rates, we may review this preference.

Source: http://www.business-standard.com/india/news/soaring-crude-oil-prices-arebiggest-risk-swati-kulkarni-/472489/