This article makes US-based NRIs aware of the taxation on the unrealised gain rule if they invest in Indian stocks, ETFs and mutual funds.

Disclaimer: Taxation is a dynamic concept, and the content of this article is valid on the date of publication and any subsequent updates. Always consult a professional tax advisor before doing anything that leads to taxes being due.

This article is a part of our detailed article series on the concept of the PFIC taxation rule applicable to US NRIs. Ensure you have read the other parts here: Show/Hide

📚 Table of Contents

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• How are US-based NRIs taxed on their investments in India
• How much tax should be paid on Indian mutual funds and ETFs?
  • Which investments fall under the PFIC category?
  • Which investments do not fall under the PFIC category?
• What should NRIs do about existing PFIC-impacted investments?
• Should NRIs invest in the name of parents in India?
• How can NRIs invest in Indian stock markets from the US even after PFIC rule?
• What should an US NRI do to become compliant with PFIC and FBAR rules on their Indian investments?

How are US-based NRIs taxed on their investments in India

The IRS requires US tax residents to pay tax at their ordinary income tax rate on investments in PFICs for every tax year (1st Jan to 31st Dec). The tax rate depends on the method used to value the PFIC:

• Mark-to-Market Method which is typical requires investors to pay taxes as ordinary income on the gains calculated as a difference between the value of the investments over the calendar year
• Excess Distribution Method which generally leads to high tax rates and should be avoided

Any NRI planning to stay in the US for some time will become a US tax resident after 183 days. The same rule applies to Green card holders as well. The 183-day rule is a part of the Substantial Presence Test and is the starting point of the calculations, including the weighted average of days present over three years, to determine US tax residency.

This tax is paid on unrealised gains. If your portfolio goes up by 10 lakhs a year, you pay 3 lakhs tax even if you did not sell anything (assuming a 30% marginal tax rate)

If we combine the above two definitions, any US-based NRI who is either a green-card holder or has stayed longer than 183 days in the US in a calendar year has to pay tax on Indian mutual funds, ETFs and AIFs (Cat 1 and Cat 3 only which do not have pass-through taxation). Direct stocks, real estate and provident fund (PPF/EPF) are not considered as a PFIC.

PFIC rules exist to prevent tax deferral by making you pay tax on gains every year.

This tax is paid on notional gains though you have not sold anything.

Warning: Taxes paid under PFIC are not refunded if you leave the US and come back to India. This rule will lead to severely lower returns on Indian mutual funds (and other PFIC eligible investments) since you have paid the tax already.

How much tax should be paid on Indian mutual funds and ETFs?

Let us assume that the NRI holds ₹10 lakhs in Indian mutual funds and ETFs on 1st January. On the following 31st December, the market value is ₹12 lakhs. Therefore, ₹2 lakhs are added to the income of the NRI and taxed at the ordinary tax rates. This tax is paid even though these investments are not sold.

If instead of ₹12 lakhs, the market value went down to ₹8 lakhs, there is no tax to be paid. But the notional loss is not allowed to offset that year’s income. Therefore if your investments go up, you pay tax, but if they go up, you don’t get the opposite benefit of lowering taxes.

As the chart shows, a portfolio of ₹10 lakhs invested in a Nifty 50 index fund on 31st December 2012 would be worth, after 1st Jan 2023, ₹33.29 lakhs without tax and only ₹23 lakhs after paying tax under the PFIC rule at a 32% tax bracket.

US tax residents must fill out the cumbersome Form 8621 while tax filing to stay within the PFIC compliance rule.

Which investments fall under the PFIC category?

• Mutual funds investing in equity or debt or both
• Exchange-traded funds (ETFs) listed in India
• Alternative Investment funds (AIFs) in the CAT1 and CAT3 categories
• Unit Linked Insurance Plan (ULIPs) since they invest using a mutual fund-like structure
• Real Estate Investment Trusts (REITs) may be PFICs if they do not perform any active business activities

Which investments do not fall under the PFIC category?

• Direct stocks: if you buy shares directly, that does not fall under the PFIC rule. Baskets like Smallcase or Portfolio Management (PMS), which invest only in stocks, are also PFIC-exempt. Such baskets must not have ETFs in them
• Indian corporate or government bonds: if you invest in bonds, say using the RBI Retail Direct portal
• NRE or NRO FDs: these are exempt under the PFIC rule, but the income is anyway taxable at your slab rate in the US
• Real estate: Rent from real estate as well as capital gains from a sale, are exempt from the PFIC classification
• Alternative Investment funds (AIFs) in the CAT2 category
• Provident fund/NPS: NPS, PPF, EPF and Sukanya Samriddhi are should be exempt from PFIC since they are considered a variation of a foreign pension plan under a particular tax treaty with India

Note: For NPS, PPF and EPF, IRS Rule 519 under the “Source of Income” category has this text:

It can therefore be interpreted that:

• Growth in NPS assets are PFIC reportable
• PPF and EPF are not PFIC reportable

What should NRIs do about existing PFIC-impacted investments?

The PFIC rule does not have a lower threshold while FATCA (Form 8938) typically applies above a threshold of USD 50,000 (double the amount when filing jointly) for unsold assets. Therefore, NRIs should check the latest value of this exemption while filing tax returns using Form 8621.

Before shifting abroad, to-be NRIs can gift assets to a family member. The gifting is tax-free for immediate family members like parents, a resident Indian spouse, or siblings. Mutual funds should be dematerialised and transferred via the on or off-market transfer process.

Should NRIs invest in the name of parents in India?

We have covered this concept in detail here: Who should invest in the name of parents to save tax? Who should not?.

How can NRIs invest in Indian stock markets from the US even after PFIC rule?

We have discussed this concept in a lot of detail here: Wall Street or Dalal Street: which is the best option for US NRIs to invest in Indian stocks based on PFIC rule?.

What should an US NRI do to become compliant with PFIC and FBAR rules on their Indian investments?

This article advises on the steps a US-based Non-Resident Indian (NRI) should take regarding unreported mutual funds in India under FBAR and PFIC rules: What should an US NRI do to become compliant with PFIC and FBAR rules on their Indian investments?