| The main purpose of this article is to increase the | | | | foreign corporation's gross income for the taxable |
| awareness of how US taxes capital gains | | | | year consist of passive income. Passive income |
| dividends from International Mutual Funds | | | | includes dividends, interest, royalties, rents, |
| US persons invested/considering to invest in | | | | annuities, net gains from certain commodities |
| Indian Mutual Funds should make themselves | | | | transactions, net foreign currency gains, income |
| aware of how US taxes capital gains/dividends | | | | equivalent to interest, payments in lieu of |
| from International Mutual Funds. | | | | dividends, income from notional contracts, and |
| Main points are: | | | | income from certain personal service contracts. |
| • Mutual Funds in India (or any other country | | | | Note that the active business of a licensed bank |
| outside US) mostly qualify as Passive Foreign | | | | or insurance business is considered active income. |
| Investment company. | | | | Under the Asset Test, a foreign corporation is |
| • These investments need to be declared to | | | | considered a PFIC if 50 percent of the foreign |
| IRS every year by June 30th. | | | | corporation's assets produce - or are held to |
| • Capital gains and dividend income from | | | | produce - passive income. In applying the Asset |
| these investments are taxed at the highest | | | | Test, the fair market value of the assets is |
| Income tax rate and not as capital gains. | | | | generally used (the "FMV Method"). |
| • Additionally deferred taxes (non-payment | | | | There are two important exceptions to these |
| of taxes till asset is sold to realize capital gain) are | | | | rules for calculation. First, Congress has recognized |
| charged interest | | | | that newly-formed corporations frequently hold |
| What is a Passive Foreign Investment | | | | short-term investments that may create a |
| company? | | | | significant percentage of income prior to the |
| A passive foreign investment company (or | | | | business truly commencing. Likewise, Congress |
| "PFIC") is a foreign company with predominantly | | | | has recognized that a firm that undergoes a |
| investment income, or whose assets are primarily | | | | change in its business may hold significant |
| intended to generate investment income. The | | | | temporary assets that generate income, creating |
| Internal Revenue Service handles the profits of | | | | a similar situation as a fledling start-up company. |
| investments in PFICs differently than their | | | | Consequences of Ownership of a PFICA U.S. |
| domestic counterparts, so U.S. investors face | | | | holder of ownership in a passive foreign |
| significant tax implications should they hold | | | | investment corporation must include as ordinary |
| ownership of a PFIC. | | | | income the allocated gains or excess distributions |
| Classification as a PFICTax code sections 1291 | | | | in its gross income for the taxable years in which |
| through 1297 provide the rules for U.S. persons | | | | the allocations are made. The tax liability is |
| who invest in passive foreign investment | | | | determined at the highest rate of tax in effect |
| companies. A foreign corporation is considered a | | | | for the applicable taxable year. Additionally, the |
| "passive foreign investment company" for these | | | | deferred tax liability from the allocations are |
| purposes if either one of two tests is satisfied: | | | | treated as underpayments of tax, and interest |
| the Income Test or the Asset Test. | | | | charges are imposed on the deferred taxes on |
| Under the Income Test, a foreign corporation is | | | | the allocated gains and excess distributions. |
| considered a PFIC if 75 percent or more of the | | | | |