Tax Planning for US Citizens/Residents
What is a PFIC?
Foreign mutual funds are treated under the United States Internal Revenue Code as "passive foreign investment companies" (PFICs). While foreign mutual funds used to offer tax deferral benefits to US investors that has not been the case since 1986. Foreign mutual funds offer no tax benefits to US investors and can even complicate matters and cause additional expenses. Note that ETFs, or Exchange Traded Funds, also fall under the PFIC rules and are thus as challenging to manage as Mutual Funds, taxwise.
Technically speaking, a PFIC is any foreign company that derives at least 75% of its gross income from passive activities or that derives passive income from at least 50% of its assets. Nearly all of the income of a mutual fund is generally passive. So, nearly all foreign mutual funds are PFICs.
How are PFICs taxed?
The US Government discourages its Citizens/Residents from investing in PFICs, perhaps thinking it may be an attempt at tax avoidance. A PFIC shareholder can choose to be taxed in any one of the following disadvantageous ways:
#1: The Excessive Distribution Method:
This is the ‘default’ method where one does not pay tax until selling the mutual funds/PFICs. In such case, the capital gains are taxed at the highest ordinary income tax rate with an interest rate of at least 9% compounded annually, regardless of the income tax bracket for the tax year in consideration. Many tax experts consider this as the least preferable tax calculation method.
Suppose you invested $100,000 in a PFIC on Jan. 1, 2010 and sell it on Dec. 31, 2019 for $1,000,000.
The tax laws require that you assume your $900,000 gain was generated in equal portions over the 10 tax years i.e. From TY 2010 to TY 2019 meaning $90K was earned in TY 2010, $90K in TY 2011 and so on. So for each of these tax years, you will be paying the highest rates of taxes plus compounded interest on those gains as if you earned the money in earlier years and avoided paying taxes then.
#2: The Mark-To-Market Election Method:
This is comparatively better when compared to above method but this election can be made only in certain circumstances.
If a shareholder makes a mark-to-market election, he must include in income the difference between the PFIC stock's Fair Market Value (FMV) at the close of the tax year and his adjusted basis. The shareholder can deduct any excess of the PFIC's adjusted basis over its FMV at the close of the tax year.
The net mark-to-market gains on the stock the shareholder included in income in prior years is not deductible. The shareholder must treat any income or loss recognized under the mark-to-market election as ORDINARY income. Additionally, the income recognized under the mark-to-market election and decreased by the deductions allowed under the election increases a shareholder's adjusted basis in PFIC stock (Sec. 1296).
Thus, even in this method, the capital gains are taxed at the highest ordinary income tax rates not at the favorable capital gains tax rates.
#3: The Qualifying Electing Fund:
Under this method, you pay tax on your long term capital gains, interest and dividends from Foreign Mutual Funds as if it is an income from US Mutual Fund. Clean accounting records should be maintained per the Foreign Government and the US Tax Laws to ensure proper fund management.
Generally, a taxpayer should make a QEF election as the first priority. However, obtaining the necessary information from the foreign corporation can prove difficult for most shareholders, especially minority shareholders. The inability to obtain this information usually eliminates the taxpayer's ability to make a QEF election.
Better Ways to Invest in India for NRIs
#1: Through US-Based Mutual Funds/Index Funds (e.g. Fidelity):
They make the work simple and send you all of the tax information at filing time. There are also a number of index funds that invest overseas, even specifically in India and are traded in the US just like stocks also referred to as Exchange Traded Funds (ETFs). (Note: If they are not managed from US then they are treated like PFICs and all the negative implications cited above will apply.
#2: Through American Depository Receipts:
ADRs represent shares in a foreign company. It is important to keep a close watch on the bid-ask spread for ADRs as it may affect thinly traded stocks to a large extent, even though the prices may be reasonable in the foreign country (such as India). The domestic US banks sponsoring ADRs may charge fairly substantial fees. Thus, owning an ADR possibly involves fees taken out of your dividends, which will vary from stock to stock.
#3: Investing in Stocks through Foreign Banks/Financial Institutions:
You need to invest $10,000 or more before this becomes cost effective, and you will then have to report your foreign accounts to the IRS on Form TDF 90-22.1 (FBAR – Foreign Bank Account Report). In some countries you will need both a bank and a securities account, because dividends may arrive as checks in a foreign currency, or because in some countries only banks can wire money back to the US for you.
When courting foreign discount brokers, be sure to ask if dividends are deposited back into the securities account -- and ask your stock broker if they can wire back to the US or can only transfer to a local bank in India. If you wish to invest, you can wire money from the US to the overseas bank/securities account using net banking services to control and invest this money. When you want to cash in, you arrange for a wire transfer back to the US. Both E-Trade and Ameritrade offer decent services for wiring of funds in/out of US.
US Citizens (Green Card Holders), Residents and US Resident Aliens can chose to invest in PFICs (Indian Mutual Funds, ETFs or other international passive funds) but it is NOT wise to do so as they are taxed on their worldwide income in the most unfavorable manner.
Article courtesy Mr. Nanda Kumar KV of Advantage One Tax Consulting, Inc.