India’s economic upspring and prosperity make it an attractive investment option bringing forth immense equity inflows from overseas. The United States of America (US), amongst others, has always been an important contributor to FDI inflows into India.
US Citizens and green card holders are subject to taxes on their worldwide income, irrespective of their residency. To avoid double taxation in the hands of US Expats residing in India, tools like foreign tax credits, foreign earned income exclusion (FEIE), and foreign housing exclusion have been incorporated.
However, in cases when the income exceeds the said limit and taxes have been paid by the taxpayer/deducted at source in a foreign country, say India and the same income is also subject to tax in the US, you may be able to take either a credit or an itemized deduction for the taxes paid/deducted in India.
The Passive Foreign Investment Company (PFIC) problem is the most common investment-related income tax issue faced by US residents living abroad who earn income through pooled investments registered outside US borders. Passive Foreign Investment Company rules under US Tax Law classify such investments as PFICs. Broadly speaking, almost any foreign investment product other than direct ownership of stocks and bonds is likely classified as a PFIC by the Internal Revenue Service (IRS).
| What qualifies as PFIC? |
| PFIC is a foreign corporation that satisfies at least one of the following requirements: |
| 75% or more of its income is classified as passive |
OR |
50% or more of the average percentage of its assets held during the year produce, or are held for the production of, passive income |
| Examples: |
| ETFs listed on foreign stock exchange |
Foreign real estate companies and real estate investment trusts (REITs) |
Foreign mutual fund trusts |
Over time, the PFIC tax drag erodes investment returns as PFIC tax rates can reach near or above 50% when considering penalties and interest. Furthermore, no deferral of gains is allowed. This means gains on a PFIC investment must be realized at a high tax rate each year (deducting losses is also limited on these investments). Additionally, each PFIC must be reported on a special tax form IRS Form 8621 filling which as per recent estimates takes up to 22 hours. Increased tax rates and complicated reporting consolidate to become a myriad pitfall for US taxpayers who own PFICs.
However, there are ways around the whole PFIC muddle to help out those who desire to build cross-border wealth. To achieve desired investment goals, the decisions regarding the hold, harvest, and divest framework must be carefully planned and implemented to build a tax-efficient portfolio that gives optimum and stable returns with minimum cost. US taxable investors should focus on building a globally diversified investment portfolio through U.S. registered funds. The investments falling under the PFIC umbrella are best liquidated so the money can be put in a place that doesn’t take away the returns in the form of high taxes and causes reporting difficulties. This bridge taking the investor away from the PFIC pitfall could be a non-PFIC investment option or these investments can be sold to a trust incorporated in Indian domicile whose ultimate beneficiary is the US expat who was the primary holder of the investments under consideration, thereby carefully lifting the PFIC veil.
Kishika Narwani
Author
A CA Finalist working as a senior assistant at Kamdar Desai & Patel LLP primarily engaged in domains of auditing, assurance, income tax compliances, and consultancy serving NRIs and foreign companies who have their operations in India. The desire to broaden her knowledge sphere about international tax provisions, case laws, and concepts in and around the tax world, brings forth articles on crisp topics providing a deep understanding within a manageable reading time.
