This story is applicable to anyone who is working in the US, is a US resident or a US citizen
17-Jan-2023 •Ashish Menon
Sometimes, you wish you still lived in the good old days. And the nostalgia surges when you hear the acronym P-F-I-C.
PFIC (Passive Foreign Investment Company) is a draconian bunch of tax rules that discourage people in the US from investing in overseas investments. This rule applies to US citizens, residents and Green Card holders.
PFIC came into force way back in 1986 but lacked teeth until recently. Increased information-sharing between tax authorities of different countries has changed all that. Now, expect the taxman to come knocking on your doors if you don't divulge your overseas investments.
When is PFIC applicable?
An Indo-US bilateral agreement exempts certain investments from PFIC rules. Some of these investments are pension funds, provident funds and direct equities (provided the companies you invest in are not generating passive income for the most part).
On the other hand, your mutual funds, ETFs and ULIPs fall under PFIC's ambit.
Why PFIC is tough on your investments
Now, let's see the three ways your overseas investments are taxed and understand if it makes sense for you to continue investing in an India-based mutual fund.
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1. Section 1291 Fund (Excessive distribution)
You are obligated to fill up Form 8621 to declare your PFIC investments.
If you forget to do so, you are automatically slotted under this category. And the bad news is that this is the most regressive of the three options.
Even though you are only taxed when you exit your investment, the gains are allocated to each year you have held the investment or become a US person, whichever is later, and then taxed at the maximum rate for each of those years.
To exacerbate matters, you are also charged interest and penalty for non-payment of tax in the years you held the investment.
For example, let's say you bought some units of mutual funds at the start of 2013 and sold them at the end of 2022 for a $10,000 gain. In this case, the gains would be allocated to each of the 10 years you held the investment (i.e., $1,000 to each of the 10 years). Then, each of the $1,000 will be taxed at the maximum rate for each of the years and a penalty of 0.5 per cent for each month of delay, subject to a maximum of 25 per cent. You also need to pay an interest based on the federal short term rate plus 3 per cent. And guess what, the interest compounds daily.
2. QEF (Qualifying Election Fund)
This is a relatively better option, as its taxation system is closest to how Washington taxes its US-based mutual fund investors.
It is the only option that recognises your gains as capital gains. That's good news because capital gains tax maxes out at 20 per cent, whereas ordinary income tax rate can go well above 30 per cent.
In other words, a mutual fund investor should choose this option in the first year of investment or get covered by these rules when you become a US person, whichever is later. If not, things can get more complicated.
That said, not all PFIC investments are eligible. The mutual fund you have invested in must comply with the IRS regulations.
3. Mark-to-Market (MTM) election
Here, the unrealised gains/losses are treated as ordinary income, not capital gains/losses. Say you made $1,000 on your Indian investment, this money would be added to your regular income and then get taxed. If you make a loss, you can adjust it with the gains you may have made in previous years.
Additionally, an Indo-US bilateral agreement provides further relief. There is no double taxation on the same gain. However, you will end up paying tax at a rate that is higher between the two countries.
Let's understand with an example. The current long-term capital gains tax in India is 10 per cent, but if you fall in the 15 per cent bracket for long-term capital gains in the US, you will need to pay the 10 per cent tax in India and the remaining 5 per cent in the US.
India-based mutual funds: To invest or not to invest?
Now that you know how the US government taxes Indian mutual funds, does it still make sense to invest in them? Let's look at what the numbers say.
Performance of India-based large-cap funds after rupee depreciation
If we look at India-based large-cap active funds, they have delivered an average of 11.1 per cent returns over the last five years (2018-2022). In the same period, the rupee depreciated by 5.3 per cent per annum. Hence, in dollar terms, these mutual funds posted an average of 5.2 per cent returns over the last five years with an average expense ratio of 0.99 per cent.
Performance of US-based India funds
In comparison, a prominent US-based India fund that invested based on a large-cap benchmark gave 2 per cent returns per annum, while charging 1.1 per cent as expenses.
Another prominent US-based India ETF investing based on a large-cap benchmark gave 5 per cent returns per annum, while charging 0.89 per cent as expenses during the same period.
Which is better?
From a performance perspective, you are better off investing in Indian mutual funds.
In addition, the tax-exempt status of Indian mutual funds gives them an advantage over their US counterparts.
This option shines even brighter if you eventually use the money in India.
Suggested read: What to do with your investments when you become an NRI?