Mutual Fund Investment: How will a US citizen PIO residing in India be taxed?

V Mallikarjun (name changed) is a Person of Indian Origin (PIO), who has become a US citizen, but is staying in India for the last five years. He is employed and paying taxes in both India and the US and is planning to invest in mutual funds (MFs) in India. He wonders how to declare the investments and if he needs to pay taxes on earnings from MF investments in the US as well.

“A US citizen is required to report all interest, dividends, wages, or other compensation for services, income from rental property or royalties, and other types of income in his US tax return. He must report these amounts from sources within and outside the United States. If a PIO (US citizen) residing in India invests in mutual funds in India, then income from such mutual funds shall be subject to tax in the US, as well,” said Dr. Suresh Surana, Founder, RSM India.

If there is no redemption, is there any need to pay taxes on the notional gains to the US government?

“Unlike India where the tax on gains is payable only on redemption or transfer, in the US the taxpayer has an alternative option of paying the taxes. To understand the taxation, it is important to know that units of Mutual funds shall qualify as Passive Foreign Investment Companies (PFIC) in the US. Any foreign (i.e., non-US) corporation meeting either the income test or the asset test (refer note 1 below) is a PFIC with respect to each shareholder / unitholders when the test is met. PFIC status applies separately for each US person owning shares / units, and also separately with respect to shares / units acquired at different times. Such PFIC includes Indian Mutual Fund as well,” said Dr. Surana.

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To explain the taxation further, Dr. Surana has given the following description –

Note 1: Income Test – If 75 per cent or more of the foreign corporation’s gross income is passive income, the income test is met. Asset Test – If 50 per cent or more of the foreign corporation’s average assets (as defined in the Internal Revenue Code) produce, or could produce passive income, or are assets (such as cash and bare land) that produce no income, then in such cases the Asset Test is met. Please note that the PFIC aspect being a complex issue needs to be examined in specific reference to the mutual fund units in which the US citizen has invested. Further, please note that the above analysis of US tax implications on Mutual funds, is subject to revalidation by tax experts in the US.

But how to pay the tax?

“The US citizen holding Indian mutual fund units may opt for Mark to Market PFIC regime, wherein he declares as income the notional gains in the market value of his funds during the year. The other option is to offer the PFIC income on sale / redemption of units. In the US, individual income is subjected to graduated tax rates (in India we call it the tax slab rates) that apply to US citizens. In the US, the highest federal tax rates for personal tax comprises federal tax (37 per cent) and further each state and local government can levy further tax on income,” said Dr. Surana.

“However, capital gains in the US on mutual funds is subject to tax based on its classification as either long term or short term, based on the specified threshold period of holding. Further, the indicative capital gains tax rate on long term gains depends on the tax slabs of the individual. For instance, the long term capital gains tax for individuals in the lowest tax bracket (10 per cent to 15 per cent) is 0 per cent, for those in the highest tax bracket (more than 37 per cent) is 20 per cent and those in other tax brackets is 15 per cent. Whereas, short term capital gains tax shall be taxed at the ordinary tax rates in the US i.e. the graduated tax rates applicable,” he added.

Is the same tax rule applicable to the PIOs/NRIs residing in other countries?

“The taxation rules for every country is different and for PIOs / NRIs residing in other countries, specific tax rules of such country needs to be referred to and there is no straight forward tax rule, which can be universally applied,” said Dr. Surana.