US Taxes Mutual Fund Investments in India

The main purpose of this article is to increase the awareness of how US taxes capital gains/dividends from International Mutual Funds

US persons invested/considering to invest in Indian Mutual Funds should make themselves aware of how US taxes capital gains/dividends from International Mutual Funds.

Main points are:
•  Mutual Funds in India (or any other country outside US) mostly qualify as Passive Foreign Investment company.
•  These investments need to be declared to IRS every year by June 30th.
•  Capital gains and dividend income from these investments are taxed at the highest Income tax rate and not as capital gains.
•  Additionally deferred taxes (non-payment of taxes till asset is sold to realize capital gain) are charged interest

What is a  Passive Foreign Investment company?

A passive foreign investment company (or "PFIC") is a foreign company with predominantly investment income, or whose assets are primarily intended to generate investment income. The Internal Revenue Service handles the profits of investments in PFICs differently than their domestic counterparts, so U.S. investors face significant tax implications should they hold ownership of a PFIC.

Classification as a PFIC
Tax code sections 1291 through 1297 provide the rules for U.S. persons who invest in passive foreign investment companies. A foreign corporation is considered a "passive foreign investment company" for these purposes if either one of two tests is satisfied: the Income Test or the Asset Test.
Under the Income Test, a foreign corporation is considered a PFIC if 75 percent or more of the foreign corporation's gross income for the taxable year consist of passive income. Passive income includes dividends, interest, royalties, rents, annuities, net gains from certain commodities transactions, net foreign currency gains, income equivalent to interest, payments in lieu of dividends, income from notional contracts, and income from certain personal service contracts. Note that the active business of a licensed bank or insurance business is considered active income.
Under the Asset Test, a foreign corporation is considered a PFIC if 50 percent of the foreign corporation's assets produce - or are held to produce - passive income. In applying the Asset Test, the fair market value of the assets is generally used (the "FMV Method").
There are two important exceptions to these rules for calculation. First, Congress has recognized that newly-formed corporations frequently hold short-term investments that may create a significant percentage of income prior to the business truly commencing. Likewise, Congress has recognized that a firm that undergoes a change in its business may hold significant temporary assets that generate income, creating a similar situation as a fledling start-up company.

Consequences of Ownership of a PFIC
A U.S. holder of ownership in a passive foreign investment corporation must include as ordinary income the allocated gains or excess distributions in its gross income for the taxable years in which the allocations are made. The tax liability is determined at the highest rate of tax in effect for the applicable taxable year. Additionally, the deferred tax liability from the allocations are treated as underpayments of tax, and interest charges are imposed on the deferred taxes on the allocated gains and excess distributions.