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.
Disclaimer: This article is for information purposes only and is not a substitute for professional tax advice. Consulting a qualified professional is essential to navigate the complexities of FBAR, PFIC, and US tax obligations for NRIs with foreign investments.
This article is a part of our detailed article series on the concept of PFIC taxation rule applicable to US NRIs. Ensure you have read the other parts here:
The article compares various investment options for US-based NRIs intending to invest in the Indian stock market.
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.
The FBAR and PFIC rules apply to:
Very few people, including qualified US CPAs, know about these rules. They will tell you a variation of:
You can get more details on the PFIC definition as well as a get a list of PFIC eligible/in-eligible investments here: Should US-based NRIs sell off their mutual funds and stocks in India?
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) in case you have paid the tax already.
As a US taxpayer, youâre required to report foreign financial accounts if the aggregate value exceeds $10,000 at any time during the calendar year. This includes bank accounts, mutual funds, and other financial assets held outside the US.
You should file FinCEN Form 114 (FBAR) electronically through the Financial Crimes Enforcement Networkâs BSA E-Filing System. The deadline for FBAR filing is April 15th (with an automatic extension until October 15th upon request).
Failure to file FBAR can result in significant penalties, so itâs crucial to disclose all relevant foreign accounts. FBAR filing is separate from tax returns. Also, as per the IRS website:
Under FATCA, certain U.S. taxpayers holding financial assets outside the United States must report those assets to the IRS on Form 8938, Statement of Specified Foreign Financial Assets.
The PFIC rule typically applies above a threshold of USD 25,000 (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. Form 8621 has to be filed yearly along with your normal tax return.
In this section, we have specifically mentioned mutual funds but the rules apply to all PFIC-eligible investments.
Under PFIC there are three ways of paying tax on capital gains which the investor must choose:
The investorâs share in the capital gains earned inside the fund (the AMC will have this data but it will be difficult to source) will be treated as capital gains (taxed at favourable rates vs. normal income tax rates) every year. This option taxes unrealised gains and falls under IRS Section 1295 reporting. Most mutual funds are not QEF-eligible and this is not a practical option for investors.
Gains in mutual funds (closing value minus adjusted basis) over the calendar year, which you can get from your MF statement, are added to your income and taxed at the marginal (highest applicable slab) rate. This option taxes unrealised gains just like QEF before it but is taxed at slab rates. There is an offset available against gains in the previous years in case of a loss this year.
DTAA (double tax avoidance) also comes into play here so you do not pay tax twice in both India and the US. If you have already paid 0-10% tax as capital gains in India, you pay the remaining amount in the US in case you are in a higher capital gains tax bracket.
If you have recently moved to the US and are planning to choose MTM election, then the fund NAV on 1st Jan 2024 will be the adjusted basis and NAV on 31st Dec 2024 will be the closing value.
This option taxes you both on gains and also applies penalties/interest on taxes not paid under PFIC in the earlier years.
The US IRS and Indian income tax authorities have data-sharing agreements in place. A key part of this agreement is the FATCA declaration which is a part of KYC in India as well as your correspondence address in your NRE/NRO account. NRIs cannot hold ordinary savings accounts in India since that is a Foreign Exchange Management Act (FEMA) violation. There is no way to hide your PFIC investments from the IRS.
Related:
Who is an NRI and who is not? Understanding FEMA and NRE/NRO bank accounts
If you have not yet declared PFIC, then you fall under the Section 1291 Fund (Excessive Distribution) category by default which kicks in when you sell your mutual funds.
Investors who have not filled Form 8621 risk a penalty of 0.5%/month up to 25% on the tax due
For example, if you have a mutual fund exposure in India worth $50,000 in 2019 and that fund doubles to $100,000 in 2024 then there is $50,000 capital gains in 5 years. This gain amount is divided equally ($50,000/5) over the 5 years and then taxed at the highest tax rate applicable to the investor for that year plus the 0.5%/month penalty. An additional interest is also charged for the delayed payment of tax, under Section 6621, in this period at the rate of federal short-term rate plus 3% compounded daily.
This âexcessiveâ tax amount can be avoided if the PFIC investment has paid at least 125% of the average distribution (dividend, bonus shares etc) of the last 3 years:
Excess Distribution = Total Current Year Distributions - (1.25 x Average of Three Prior Years Distributions)
If you get 5% dividends from your Indian mutual funds, which is unlikely since most investors invest in Growth and not IDCW plans) and this dividend is increasing, then the excess distribution clause may get triggered which avoids the punitive tax.
| Year | Delay in months | Penal interest % | Tax w/ penalty | Total w/ Interest |
|---|---|---|---|---|
| 2023 | 3 | 1.5% | $385 | $396 |
| 2022 | 15 | 7.5% | $445 | $511 |
| 2021 | 27 | 13.5% | $505 | $647 |
| 2020 | 39 | 19.5% | $565 | $808 |
| 2019 | 51 | 25.0% | $620 | $989 |
The above table shows the taxation for an investor with $1,000/year of capital gains. The investor has a marginal personal tax rate of 37%.
If we calculate the cumulative tax due on the investor, as a percentage of the total PFIC-eligible gains, we get
| Year | Total tax due |
|---|---|
| 2023 | 40% |
| 2022 | 45% |
| 2021 | 52% |
| 2020 | 59% |
| 2019 | 67% |
Please note that this tax % amount is on the total PFIC gain. For the $50,000 gain example above, the tax with penalty and interest will be 67%.
Investors who have not filled Form 8621 fall under two categories:
In all of these options, you will still need to pay the required tax. Some options may or may not avoid penalties.
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This post titled What should an US NRI do to become compliant with PFIC and FBAR rules on their Indian investments? first appeared on 14 Apr 2024 at https://arthgyaan.com
