Indian shares and mutual funds: capital gains and the PFIC problem

There are two quite different cases here, and the difference can mean a large gap in tax.

Shares of Indian companies, held directly

Shares of an ordinary operating company are not a special asset in the US. Gains are capital gains in dollars: cost converted at the purchase date rate, proceeds at the sale date rate, held more than a year for long-term. Dividends are reported on Schedule B (see interest and dividends).

In India, NRI gains on listed shares are taxed at 12.5% long-term (above an annual exemption of Rs 1.25 lakh) and 20% short-term, for sales on or after 23 July 2024. Securities transaction tax is not an income tax, so it does not produce a credit. The credit for that Indian tax is the complicated part. The US generally treats a resident's gain on shares as US-source, and a credit is only allowed against foreign-source income, so the Indian tax may be uncreditable unless the treaty re-sourcing rule is used (foreign tax credit). A preparer should check this before the return is filed.

Mutual funds: PFIC

An Indian mutual fund (and most Indian ETFs, REITs, ULIPs and gold funds) is a passive foreign investment company (PFIC) for US purposes. The default tax treatment was designed to be punitive:

• Gains and "excess distributions" are spread over the years you held the fund and taxed at the highest ordinary rate for each year, with an interest charge.
• The lower capital gain rates do not apply.
• Form 8621 is required every year for each fund, except when below a small combined value limit ($25,000, or $50,000 jointly) and no distributions or sales occurred.

A $10,000 SIP gain that Indians would treat as low-tax equity gain can be taxed at 37% plus interest in the US.

The elections and why they usually do not help

• Qualified electing fund (QEF). Taxes you each year on your share of the fund's income. It needs a PFIC annual information statement from the fund, which Indian fund houses generally do not provide.
• Mark-to-market. Taxes unrealised gain each year as ordinary income. It is only open for funds whose shares trade on a qualifying exchange. Unlisted open-ended funds usually do not qualify; exchange-traded funds on the NSE may be argued to, and the rule is technical.

Without an election, the excess distribution rules apply, and the compliance cost on top of it is large. Many tax professionals advise NRIs who become US residents to:

1. Stop adding to Indian mutual funds.
2. Compare the cost of selling (US tax at the PFIC rate on past gain) with the cost of holding.
3. Move into directly held shares, or US-domiciled funds.

A "purging election" and other methods exist when the holding start date matters.

What not to do

• Do not leave PFICs off the return because there is no US 1099. The time the IRS has to assess tax on items related to the fund stays open until the form is filed.
• Do not assume the fund is excluded because it is a "growth" or "equity" scheme. The test is the legal form.
• Do not forget demat accounts and fund folios are also reportable (FBAR).

If you hold Indian mutual funds and have a US filing history that did not include Form 8621, this is a priority to get advice on before any redemption.