- Wealth PMS
India has become a popular investment destination for domestic and international investors thanks to its strong economy, robust growth potential, and diverse investment opportunities. For US citizens living in India, understanding the nuances of investing in India is crucial to maximizing their returns while staying compliant with US tax laws. One such regulation that US citizens must be aware of is the Passive Foreign Investment Company (PFIC) rules. In this article, we will explore the concept of PFIC, the types of investments that fall under its purview, and those that do not. We will also discuss the pros and cons of various investment vehicles like equity mutual funds, debt mutual funds, ETFs, and direct equity investments for US citizens investing in India.
The PFIC rules were introduced in the United States in 1986 to discourage US taxpayers from investing in passive foreign investments that could potentially defer or reduce their US tax liabilities. A PFIC is a foreign corporation that meets one of the following criteria:
- At least 75% of its gross income is passive income (interest, dividends, capital gains, etc.)
- At least 50% of its assets produce passive income or are held for the production of passive income.
PFIC investments, if held on the end of the year, are taxed on unrealised gains. That means they are taxed as if they were sold and bought back on December 31 each year. The gains are included as “ordinary income”, and do not get a capital gains benefit. Losses are disregarded until actually realized. Meaning, if you have one fund that has lost value and another that has gained value, you’ll pay tax on the gains but are not allowed to offset the losses.
Remember, US citizens (and green card holders) must file taxes in the US on worldwide income, regardless of whether they are resident in the US or not. That means even if a US Citizen lives in India, his investments in India may be classified as PFIC and taxed in the US accordingly.
Investments under the Ambit of PFIC
For US citizens investing in India, it is essential to understand which investments come under the ambit of PFIC to ensure compliance with US tax laws. The following investments are generally considered PFICs:
- Mutual Funds: Equity and debt mutual funds domiciled in India are generally classified as PFICs. This is because these funds generate income primarily from dividends, interest, and capital gains, which are considered passive income.
- Exchange-Traded Funds (ETFs): Indian listed ETFs that track Indian stocks or bonds also come under the purview of PFIC regulations. These ETFs derive income from the underlying securities in a manner similar to mutual funds.
- Indian AIFs: Cat 1 and Cat 3 Alternative Investments Funds also are a PFIC in the US rules
- Certain Foreign Holding Companies: Some Indian holding companies with significant investments in passive income-generating assets may be classified as PFICs.
- ULIPs: Unit Linked Insurance Policies are considered to be PFIC.
Investments not considered PFIC
The following investment vehicles are typically not considered PFICs:
- Direct Equity Investments: Investing directly in Indian stocks is not subject to PFIC rules
- Direct Bond investments: Buying bonds or debentures in India do not qualify as PFIC either
- Real Estate Investments: Direct investments in Indian real estate are also not subject to PFIC rules, as rental income and capital gains from the sale of real property are not considered passive income for PFIC purposes.
- Fixed deposits: They are not considered a PFIC but there is no benefit because interest is taxable both in India and the US for Indian residents that are also US citizens
- Pension funds: Most pension funds like EPF, PPF etc, are not considered PFIC due to a special dispensation for pension products.
- Cat 2 AIFs: AIFs with pass through taxation may be exempt from PFIC rules if they pass on all income and gains/losses to unit holders.
Filing and Tax considerations
You need to file form 8621 if you have any PFIC investments in the year, with a separate page for every single investment made (if investments were made in chunks, then for each day of investment, a new Part V of form 8621 needs to be filled)
This can be extremely painful and therefore, US citizens or residents should just avoid it completely.
Note that dividends and interest are taxable as income.
Pros and Cons of Various Investment Vehicles for US citizens investing in India
Equity Mutual Funds
- Professional management and diversification reduce risk.
- Access to a wide range of sectors and companies.
- Systematic Investment Plans (SIPs) enable disciplined investing.
- PFIC reporting requirements lead to complex tax filings and potential tax liabilities.
- Management fees and other expenses can impact returns.
Debt Mutual Funds
- Relatively stable and predictable returns compared to equity funds.
- Professional management and diversification across various debt instruments.
- Suitable for conservative investors seeking capital preservation.
- PFIC reporting requirements and potential tax liabilities.
- Interest rate risk and credit risk can impact returns.
- Lower long-term returns compared to equity investments.
- Offers diversification and professional management like mutual funds.
- Lower management fees compared to mutual funds.
- Can be bought and sold like stocks, offering intraday liquidity.
- PFIC reporting requirements and tax complexities.
- Limited availability of India-focused ETFs on US exchanges.
- May suffer from tracking errors and liquidity issues.
Not subject to PFIC rules, simplifying tax reporting.
- Potential for higher returns due to direct exposure to individual stocks.
- Complete control over investment decisions.
- Requires extensive research and expertise to select the right stocks.
- Higher risk due to lack of diversification.
- Time-consuming and requires active involvement in managing the portfolio.
Portfolio Management Services (PMS)
- Avoids PFIC rules as the investment is always made in your account, and you’re the beneficial owner of the underlying shares (or bonds). PMSes can be instructed to not buy mutual funds or ETFs.
- Personalized and tailored investment strategies to suit individual risk profiles and investment objectives.
- Access to experienced portfolio managers with expertise in the Indian market.
- Greater flexibility in choosing stocks and investment strategies compared to mutual funds and ETFs.
- High minimum investment requirements, making it less accessible for retail investors.
- Management fees can be higher than mutual funds or ETFs.
Alternative Investment Funds (AIFs)
- Access to alternative asset classes like private equity, venture capital, and real estate, which can enhance diversification and potentially higher returns.
- Professional management by experienced fund managers.
- May offer lower correlation with traditional asset classes, reducing overall portfolio risk.
- High minimum investment requirements, making it suitable only for high-net-worth individuals or institutional investors.
- Illiquid investments with longer lock-in periods.
- Some AIFs may be classified as PFICs, depending on their investment strategies and income sources, leading to complex tax reporting and potential tax liabilities.
For US citizens residing and investing in India, it is crucial to understand and navigate the complexities of PFIC regulations to ensure compliance with US tax laws while optimizing returns. While direct equity investments and real estate are generally not subject to PFIC rules, other investment vehicles like mutual funds, ETFs, and some AIFs may fall under the purview of PFIC, leading to tax complexities and potential liabilities.
In choosing the right investment vehicle, US citizens should carefully consider their risk appetite, investment goals, and the potential impact of PFIC rules on their tax liabilities.
Portfolio Management Services (PMS) are a viable investment option for US citizens investing in India, especially when opting for a PMS provider with an established track record and credibility. A PMS avoids PFIC classification if you tell the PMS to avoid investing in bonds or ETFs. A well-managed PMS offers personalized investment strategies, experienced portfolio management, and a more tailored approach, which can make it a preferred option for some investors.
Engaging a registered investment adviser with expertise in helping US citizens invest in India can provide valuable guidance in navigating the intricacies of PFIC regulations and selecting suitable investment options that align with the investor’s financial objectives. With their knowledge and experience, an investment adviser can help US citizens make informed decisions about PMS and other investment vehicles to build a diversified, tax-efficient portfolio that meets their financial goals.
Capitalmind Wealth is a PMS offering active equity investment portfolios to Indian-residend US Citizens looking to invest in India for long-term capital appreciation.
Click here to know more about us, and to schedule a call with our team to explore if we’re the right partner for your needs.
This post is for information and should not be considered tax-planning or investment advice.