Topic 3:- IRS Rules on Passive Foreign Investment Companies (PFICs) and Indian MFs

If you are a U.S. tax resident, whether on an H1B, L1 visa, or a Green Card, your Indian mutual funds are categorized as Passive Foreign Investment Companies (PFICs). The IRS created these rules to prevent U.S. taxpayers from deferring taxes through offshore “pooled” investments. In 2026, staying compliant is more critical than ever, as the IRS has increased automated matching with Indian financial data via FATCA.

1. The Two Tests: Is Your Fund a PFIC?

A foreign entity (like an Indian Mutual Fund or ETF) is classified as a PFIC if it meets either of these two tests annually:

• The Income Test: 75% or more of its gross income is “passive” (dividends, interest, capital gains).
• The Asset Test: 50% or more of its assets produce, or are held to produce, passive income.

2. The “Excess Distribution” Trap (Section 1291)

If you do not make a special election (like Mark-to-Market), the IRS applies the Section 1291 default method. This is the most punitive way to be taxed:

• Highest Marginal Rates: Your gains are taxed at the highest ordinary income rate (37% for 2026), regardless of your actual tax bracket.
• Daily Compounded Interest: The IRS calculates tax as if you earned the gain evenly over your holding period and charges you interest for every year you “deferred” that tax.
• Total Loss of LTCG: You lose the 15-20% Long-Term Capital Gains rate entirely.

3. 2026 Reporting Thresholds & “De Minimis” Rules

You generally must file Form 8621 for each fund if your total holdings exceed these amounts on the last day of your tax year:

The “Any Amount” Exception: Regardless of the thresholds above, you must file Form 8621 if you received any distribution (dividends) or sold any shares of an Indian mutual fund during the year.

4. Safe Alternatives to Avoid PFIC Rules

To bypass the complexity of Form 8621 and punitive interest, consider these “PFIC-safe” strategies for 2026:

• Direct Indian Stocks: Individual shares of companies (e.g., Reliance, Infosys) are not PFICs. They qualify for standard U.S. capital gains rates.
• U.S.-Domiciled India ETFs: Investing in funds like $INDA or $EPI gives you Indian market exposure but issues a standard 1099, avoiding PFIC status.
• GIFT City AIFs: Specific funds in India’s GIFT City can be structured as non-PFICs for U.S. residents by electing to be treated as a corporation (Form 8832).

How KKCA Secures Your Status

We specialize in untangling the “PFIC knot” for high-net-worth NRIs:

• Election Optimization: We calculate whether the Mark-to-Market (MTM) election or staying in the default regime is the cheaper path for you in 2026.
• Basis Reconstruction: We track your NAV in USD from the day you became a U.S. resident to ensure you only pay tax on gains earned while under IRS jurisdiction.
• Amnesty Programs: If you have years of unreported Indian funds, we use the Streamlined Filing Compliance Procedures to bring you into compliance while minimizing penalties.

Call to Action

Looking for personalized tax services about your specific tax situation? Please contact us. We are here to help you with your specific tax matters.

Frequently Asked Questions (FAQ)

Q: Are Indian Fixed Deposits (FDs) or PPF considered PFICs? A: No. FDs are bank accounts, and PPF is a government-backed savings scheme. They are reported on FBAR/FATCA but do not require Form 8621.

Q: Can I use the India-U.S. Tax Treaty to avoid PFIC tax? A: No. While the treaty allows for Foreign Tax Credits (FTC) to prevent double taxation on the income itself, it does not exempt you from the PFIC interest charges or the higher tax rates.

Q: What is the penalty for not filing Form 8621? A: While there isn’t a fixed dollar penalty for Form 8621 itself, failing to file it keeps the statute of limitations open indefinitely for your entire tax return, allowing the IRS to audit you many years later.

Disclaimer

This blog is intended for informational purposes only and does not constitute legal or tax advice. Please consult a qualified U.S. CPA or tax attorney for guidance specific to your situation.