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December 13, 2022

How capital gains are taxed for NRIs by investing in Indian MF

by CA Shivam Jaiswal in Income Tax, Stock Market

How capital gains are taxed for NRIs by investing in Indian MF

In India, mutual funds could be a fantastic investing option.Long-term capital gains on equities funds are tax-free, as are dividends. And if you have been a long term investor chances are, you built a fairly good corpus thanks to the robust Indian equity market.

A non-resident Indian (NRI), or Indian citizen living abroad as defined by the Foreign Exchange Management Act (FEMA), 1999, is able to invest in mutual funds (MFs) in India.The important condition is that investments must be made through an NRE (Non-Resident External) or NRO (Non-Resident Ordinary) denominated account any bank in India

The regulations governing the taxes of Indian MF income in the US and Canada are complicated. Also, the compliance requirements for asset management companies to allow NRIs to invest are stringent Some fund houses don’t allow such investments, while others allow them in offline mode with a declaration that the investor was based in India at the time of the initial investment.

When is an individual deemed to be a US or Canadian resident for the purposes of tax compliance?

US: It is based on the number of days an individual has stayed here—183 days is the threshold. To be considered as US tax residents, the total of all days stayed in the US in the current year, plus one-third of all days in the previous year and onesixth of all days in the year prior to that should be more than 183 days. Green card holders are considered residents regardless of the substantial presence requirement.

Canada: Subject to certain criteria, those who are physically present in Canada for more than 183 days within a calendar year are considered to be tax residents under Canadian rules. There is also another way to determine tax residency here, and it is based on facts and circumstances. Let’s assume that a person migrates to Canada this year in November and establishes himself there. No matter how many days they spent in Canada prior to November, they  considered as a resident as of that month.

How are capital gains from investments in Indian MFs taxed?

US: Passive Foreign Investment Company (PFIC), which was formed to discourage investments in foreign mutual funds, taxes income from Indian mutual funds in the US. Form 8621 is the required format for reporting the related information under PFIC. The “excess distribution technique” (the default option), the “qualified electing fund” approach, and “mark to market reporting” are all options for taxing MF income under PFIC. For instance, a US citizen might put his money in an investment company or mutual fund situated in the Cayman lands Cayman Islands does not require its funds to make distributions to its investors and therefore there is no tax or annual basis. At the time of sale, while capital appreciation would be tax free in the Cayman Islands, the US citizen/resident would still have to pay tax in the US since he is taxed on his global income. By doing this, he could defer his US tax liability till the time of actual sale. So while the Intent of the PFIC rules was to plug such incidents, foreign mutual funds, being of similar structure, also fall under this Category Broadly speaking, according to the PFIC rules, the citizen will face some harsh tax consequences.

The most popular approach is to use a Qualified Electing Fund, wherein the appreciation in investment value, It’s crucial that taxpayers choose this option in their first year of filing returns in the US. After that, picking this option would be challenging.

The difference between the fair market value of the holdings at the end of the year and the adjusted cost each year will be taken into account for the computation of “ordinary income” in Mark to Market reporting, which will be taxed at individual income slab rates. This technique allows for any losses to be set against any benefits. . The default method, which gets applicable if either of the above two options is not selected, is extremely punitive.

The default method, which gets applicable if either of the above two options is not selected, is extremely punitive. Simply said, the capital gains from selling MFs could be allocated over the full holding period and taxed at the investor’s highest marginal rate in each year. Further, it also charges interest penalty considering that the taxes were not paid in the previous years.

Canada: In this country, capital gains are taxable on 50% of the actual gains taxable in India.If you sell MF units and make a capital gain of $100, only $50 of that gain is subject to reporting in Canada as a taxable capital gain at the individual’s marginal tax rate.

What are the applicable tax rates?

US: Taxes are levied at two levels – the federal level and the state level. At the federal level, the ordinary income is taxed at rates applicable to the individual tax payer, in the range of 10% to 37%. State taxes may vary from 0 to 13.3%. Based on a one-year holding period, long-term capital gains (LTCG) and short-term capital gains (STCG) are differentiated. While LTCG is taxed at either a 0, 15, or 20% tax rate, STCG is taxed as “ordinary income” at the individual’s applicable tax rate. Over and beyond federal taxes, state taxes are decided on a case-by-case basis. Some states (such as California) do not regard PFICs in the same way as the federal government. Taxes and income are not recognised until after a distribution is received or a disposition has taken place. If the tax payer’s gross income exceeds a predetermined threshold, an additional 3.8% net investment income tax rate is due.

Canada: The province in which a taxpayer resides determines the capital gains tax rates that are applicable. Quebec state has the highest rate at 54%. In that situation, the overall gain tax rate will be 27%. since the taxable portion of capital gains is just 50%. There is no difference between LTCG and STCG in Canada.

Tax credit provisions in US or Canada for the tax already paid in India?

US: Foreign tax credit essentially permits a US resident to offset any taxes that is paid on income in India and that is double taxed on the US tax return. One must submit Form 1116 in addition to the tax return in order to claim the foreign tax credit. Any overseas tax credit that you are unable to use up can either be carried forward for ten years or back one year.

Canada: If any tax is paid in India, whether it’s withholding tax or any actual tax, you can report that as a foreign tax credit in the Canadian tax return. Just a prorated amount of the tax paid in India would be credited in Canada, it should be noted. Only 50% of the capital gains tax paid in India will be eligible for a tax credit because 50% of capital gains are taxed in Canada.

Is there any grandfathering clause for the gains made on investments before moving abroad?

US: The grandfathering clause does not exist. Additionally, if you are a US tax resident, your worldwide income is taxable. For the purpose of calculating taxes in the US, the original cost of acquisition would be considered the cost of MF investments. On the same income, there won’t be any double taxation, though.

Canada: The cost of MF investments held in India will be the fair market value of such investments on the date of becoming a resident. That is, the capital gains made before an individual becoming a resident is not taxable in Canada.

What are the compliance requirements?

US: Details of the MF units you possess, the total number of units in that MF, and its worth at the end of the year are some of the pieces of information that must be filled out on Form 8621.People might be required to provide separate reports for each of their mutual fund investments, detailing the underlying investments in each scheme. These details might not always be readily available, and finding them might take a long time.

Canada: Generally, investors in Indian mutual funds only report capital gains when they sell their units. However, sometimes, there is a requirement to do a review of the structure of the foreign holding (Indian MFs), on a case-to case basis, to decide if the reporting is required. Individuals who have more than $100,000 invested outside of Canada may be required to comply with this.

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