In July we reported that India and the United States signed an agreement to implement the Foreign Account Tax Compliance Act (FATCA). The agreement is designed to increase transparency between the two nations on tax matters and took effect September 30, 2015. We are now seeing the results of this agreement on U.S. residents and Green card holders who own Indian or other non-U.S. mutual funds.
Mutual funds in India appear to be a tax-conscious investment vehicle because in India dividends are tax free up to U.S. $15,000, and long term capital gains on equity and mutual funds are also tax free. However, for Indian Americans, Non-Resident Indians, and Americans living and working in India, the U.S. tax consequences of Indian mutual fund ownership far over-ride the benefits. Because the United States levies tax on the world-wide income of U.S. residents and citizens, income from non-U.S. mutual funds, which are considered Passive Foreign Investment Companies, is taxed in the U.S. under the U.S. tax regime and at U.S. rates.
Tax Consequences of FATCA
Previously, the U.S. tax laws related to non-U.S. mutual fund ownership were easy to ignore because the Internal Revenue Service (IRS) had no way of knowing if U.S. residents owned non-U.S. mutual fund shares unless they self-reported. That changed with FATCA. Under FATCA, each foreign financial institution reports the names, addresses, tax identification numbers, account numbers, and account balances of each account holder that is a citizen or resident of the U.S. to the IRS. When the IRS is notified of an individual’s ownership in non-U.S. mutual funds, it determines if the individual filed Form 8621 – Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. If the individual has not appropriately reported the holdings, the IRS can levy stiff penalties.
But it’s not just the penalties for non-compliance that taxpayers should be concerned with. The tax and reporting burden for non-U.S. mutual funds is onerous. Non-U.S. mutual funds, hedge funds, and many insurance products fall under the gambit of “Passive Foreign Investment Companies” (PFICs). PFICs came into being in the Tax Reform Act of 1986 as a way to discourage U.S. taxpayers from using offshore tax shelters, and the tax treatment was designed to be particularly burdensome. Under the PFIC tax regime, all income is ordinary income automatically taxed at the top individual tax rate (39.6 percent for 2016). In fact, the total tax on a PFIC investment could be 50 percent or more, and losses cannot be used to offset capital gains.
Further, for each PFIC investment, the taxpayer must file a separate Form 8621 each year. By the IRS’s own estimate, the three-page form can take more than 20 hours to prepare. Investors who hire tax accountants to prepare their returns could pay thousands of dollars just in tax preparation fees related to the Form 8621.
Now that FATCA has given the IRS an open window into U.S. taxpayer’s offshore investments, U.S. citizens and residents should carefully review their foreign investments to determine if any of their holdings constitute a passive foreign investment company. Taxpayers should then plan their investments with the PFIC tax regime in mind. In the end, for a U.S. taxpayer, the best course will likely be to invest in a comparable U.S.-based mutual fund, rather than a non-U.S. fund.
This article was first published May 2016.
Since its establishment in 1992, Dezan Shira & Associates has been guiding foreign clients through Asia’s complex regulatory environment and assisting them with all aspects of legal, accounting, tax, internal control, HR, payroll and audit matters. As a full-service consultancy with operational offices across China, Hong Kong, India and emerging ASEAN, we are your reliable partner for business expansion in this region and beyond.