Why Indian Mutual Funds are a PFIC tax compliance headache for US based NRIs

I was recently looking at the US Tax Return of a friend (let's call him Vijay), who works in the US. He is Indian by citizenship. I was shocked to see the detailed filing of his Indian mutual fund investments. Each of the mutual funds was reported in a separate form with information on any dividends, interest or sale proceeds. 

One mutual fund, which had been sold in the previous calendar year, was taxed at the maximum marginal rate of US (about 37%). Not just that, the gains were distributed over the entire period of holding (overlapping with US tax residency) and additional interest was levied for those years.

My head was spinning. I asked Vijay about this treatment. 

"Well, the tax firm that files for me has done all of this. I just give them the information. No idea otherwise." He was quite casual about it.

For a while, I was blank and the only question that came to my mind was, "With such a punitive tax treatment, why would NRIs in the US invest in Indian Mutual Funds?"

That was a start of some serious learning about why this treatment was meted out by US tax laws. Well, for starters, Indian MFs (and most non US mutual funds) are classified as Passive Foreign Investment Companies (PFICs) under US tax law, leading to complex, punitive taxation and heavy reporting requirements.  

I also wondered as to what Vijay could do to manage this punitive tax law better. Well, let's cover some ground on the key tax laws around PFICs and if there is a better way for US based NRIs as well as Green Card holders to participate in the India growth. 

Key Concepts around Tax and PFIC

• US Tax Residency:If you meet the Substantial Presence Test (≥31 days in the current year and the 3-year formula ≥183 days: current year days + 1/3 prior year + 1/6 two years prior) or hold a Green Card, you are taxed on your global income. To avoid residency, ensure either <31 days in the current year or the formula <183 days.

• PFIC rules: Most pooled investment vehicles, including Indian Mutual Funds, qualify as PFICs because ≥75% of their income is passive (e.g., dividends, capital gains) or ≥50% of assets produce passive income. This triggers special US taxation:

  • Under the default Excess Distribution Method, gains are allocated over the holding period, taxed at 37% for US tax resident years plus interest for prior years.

  • Mark-to-Market (MTM) election taxes annual unrealized gains at 37%, avoiding interest but requiring cash even without selling. Still very high!

  • Qualified Electing Fund (QEF) election is infeasible due to lack of PFIC Annual Information Statements (say from Indian funds).

• Reporting Requirements: US tax persons need to file IRS Form 8621 for each PFIC (even without sales), FinCEN Form 114 (FBAR) for foreign accounts >$10,000, and Form 8938 for foreign assets >$50,000 on the last day of the year (or >$75,000 anytime; higher thresholds if living abroad).

Any non compliance may lead to audits, interest and penalties. 

What could Vijay do about his Indian Mutual Funds?

Vijay moved to the US in 2019 and has stayed long enough to meet the Substantial Presence Test making him a US Tax resident since around 2021. He has over ₹2 crores in Indian Mutual FUnds (all growth options, held for 5 to 10 years and has been buying regularly). While he has been filing his US taxes diligently, he has overlooked the PFIC driven rules. 

His Indian MFs are PFICs, so any gain on a sale triggers excess distribution (the default method) taxation—e.g., a ₹20 lakh gain could cost 37% US tax (₹7.4 lakh) plus interest (₹1-2 lakh) for US residency years, even if no dividend, interest was paid out, or any cash sale made.

Now, if he plans to return to India then he can tightly hold on to his funds (make no sale), use the excess distribution method of reporting in his US tax returns and sell the funds, if required, only when he moves back to India. (Assuming he has growth options and no dividends, that saves on any taxes, only reporting required in the US).

If that is not the case and let’s say he is planning to stay there, maybe even get a US Green Card, then a different approach may work better.

A better thing to do would be to sell the Mutual Funds and shift to an India Stocks portfolio. 

The Long term capital gains in India is at 12.5% currently and is creditable against the US long term capital gains tax of 15 to 20%. Plus, Stocks have no PFIC complexity.

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An additional word for Indians with US Green Card

You are a US tax person, irrespective of wherever you are in the world, and have to report and pay taxes on global income. So, for your plan to invest in India, consider stocks instead of mutual funds - better taxes, less compliance headache.

The only thing you need to beware about is not to make random investments. Consider working with an advisor who can help you build the right stocks portfolio based on a stated strategy or help you identify any PMS that can suit your requirements. 

Disclaimer

This article is for informational and educational purposes only, based on publicly available information from the U.S. Internal Revenue Service (IRS), the Indian Income Tax Department, and general real-life observations of cross-border tax scenarios as of September 19, 2025. It is not intended to provide, and should not be construed as, tax, legal, financial, or investment advice. Tax laws and regulations are complex, subject to change, and highly dependent on individual circumstances. Always consult a qualified tax professional or advisor familiar with U.S.-India cross-border taxation before making any decisions regarding investments, filings, or strategies.