Why US NRIs should never invest in Indian Mutual Funds
Disclaimer: I’m not a financial expert. I like finance and I present my opinions based on my own research. You need to consult a finance, legal and/or tax professional for your specific needs. I post this in individual capacity as a personal post.
If you are an Non-Resident Indian (NRI) residing in the US then you should never invest in Indian mutual funds. That sounds harsh and the truth is it is.
As an NRI you can invest in Indian mutual funds. You have to setup a trading account in India and you have to be physically present in India to buy mutual funds. Even if you can you shouldn’t.
Indian mutual funds fall under the category of Passive Foreign Investment Company (PFIC). The rules were originally crafted by IRS to eliminate offshore tax havens for US residents but unfortunately Indian mutual funds got caught in this classification.
According to this, an NRI who invest in Indian Mutual Fund has to file Form 8621 every year when filing taxes in the US even if the person does not sell the investment. For regular mutual fund investors there are two options available.
Option 1: Mark to market
If you buy a mutual fund in a year you have to calculate your gain or loss at the at the end of the year even if you didn’t sell the mutual fund. IRS will consider this gain as ordinary income and tax it at the marginal rate.
For example if you had bought mutual fund for Rs. 200,000 in March 2017 and didn’t sell it at the end of the year you have to calculate the value on Dec 31, 2017. Let’s say its value is Rs. 220,000. You have to report Rs. 20,000 as additional income and that will be taxed at your highest tax bracket.
Let’s say you didn’t sell the mutual fund in 2018. Your adjusted price on Jan 1st, 2018 will be Rs. 220,000. On Dec 31, 2018 you have to find out the value this investment. Assume that it is Rs. 250,000. For 2018 your capital gains are Rs. 30,000 and you have to add it to your income and pay taxes at the marginal rate.
You have to repeat this process every single year till you sell your mutual fund.
Option 2: Excessive Distribution method
According to this method you do not pay any tax during your holding period. You pay taxes only when you sell the mutual fund.
For example if you bought a mutual fund on July 1, 2013 for Rs. 1,00,000. You sold it on August 15, 2017 for Rs. 1,25,000. You don’t report it when filing taxes for 2013, 2014, 2015 and 2016. You report it only when filing taxes for 2017. Your gain will be Rs. 25,000. This will be distributed equally across all tax years you held the investment. So it will be Rs. 5,000 per year.
You will pay the highest ordinary income tax for each year on this gain. In addition to this you will have to pay interest for failing to pay taxes in 2013, 2014, 2015 and 2016. The total tax rate can approach 50% in some cases. This method is generally disadvantageous compared to mark to market method.
The only exception to filing form 8621 is if your total Indian mutual fund holdings is less than $25,000 for single filers and $50,000 for married couples filing jointly. Even with this exception the PFIC tax law is very confusing.
To make it even more unattractive, you will also pay taxes on your capital gains in India. It will be deducted at source (TDS — Tax Deducted at Source) when you sell your mutual fund. It is unclear whether you can claim that tax credit with PFIC. IRS doesn’t have definitive guidelines on getting tax credit for mutual fund capital gains taxes paid in India and tax professionals do not have a definitive answer to this.
Given the extremely complex nature, excessive taxation and uncertain foreign tax credit, NRIs in the US must avoid investing in Indian mutual funds.
