U.S. Tax on Indian Mutual Funds – IRS Basics of Indian Mutual Funds
The United States follows a worldwide income taxation model. This means that under most circumstances, subject to exceptions, exclusions, limitations and other treaty rules, the IRS taxes you presently, on your worldwide income.
While there are exceptions to taxation of certain dividends (mainly corporate-to-corporate issuances), unfortunately there is no default exception for Indian Mutual Funds.
In other words, the IRS taxes Indian Mutual Funds on the interest, dividends and capital gains that it generates each year.
Worse yet, like almost all mutual funds, an Indian Mutual Fund will fall into the PFIC category…which is not a good thing.
IRS Tax on India Mutual Funds
Under India Tax Law, oftentimes taxes can be avoided when dividends are immediately re-invested. When the dividends are distributed (usually into a linked SBI or ICICI account), the tax rules are more complex (long-term vs. short-term dividends) but overall India maintains very generous tax rules for Mutual Fund dividends.
The IRS is not as generous…
U.S. Tax on Indian Mutual Funds
The U.S. taxes dividends earned from Indian Mutual Funds. But, as to whether a person will be subject to tax now, or at a later date is determined by whether the individual is having those dividends distributed, or whether they are accruing within the mutual fund account.
A Quick Note – Foreign Mutual Funds are Considered PFICs
A PFIC is the acronym for Passive Foreign Investment Company. Analyzing PFICs is very complicated and is considered one of the most complicated aspects of international tax/foreign investments.
Unfortunately foreign mutual funds are typically considered PFICs. The reason why this is so important, is because it will significantly impact how the IRS taxes your foreign mutual fund investment.
Mutual Fund PFIC – No Distributions
If you have invested in into foreign mutual fund in India, and the fund has not issued any dividends (or capital gains/interest) for that matter, then typically the IRS is not going to tax the investment just yet.
Rather, what happens is at a future date when in the initial distribution occurs, it will be considered an excess distribution and form the basis for a PFIC excess distribution calculation – unless a proper and timely election was made beforehand such as a QEF or MTM.
*There are very strict limitations in trying to go back and make a late/retroactive election.
**The tax analysis for an excess distribution is very complicated and oftentimes results in a tax rate neighboring somewhere between 45% and 65% for excess distributions.
Mutual Fund PFIC – Distributions
If a person receives distributions from an Indian Mutual fund, the IRS is going to tax the distribution — even if it was tax-free in India. And, depending on how much dividend is being distributed and what portion is considered excess distribution will determine what tax rate will apply.
Mutual Fund Reporting
Indian mutual funds are considered foreign accounts and therefore must be reported to the IRS each year, unless it meets the requirements for exclusion. Depending on the value of the mutual fund and whether or not any particular exemption, exclusion, or limitation applies, will determine what specific form(s) must be filed regarding the reporting.
Out of IRS Mutual Fund Reporting/Tax Compliance?
If you are out of IRS compliance, and have not properly filed or reported your Indian mutual funds and/or paid the necessary U.S. tax, you may be subject to various fines and penalties depending on which forms you are required to file, and how long the funds have been in existence – since this will help determine with the US tax will be.
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Sean holds a Master's in Tax Law from one of the top Tax LL.M. programs in the country at the University of Denver. He has also earned the prestigious IRS Enrolled Agent credential. Mr. Golding's articles have been referenced in such publications as the Washington Post, Forbes, Nolo, and various Law Journals nationwide.