Taxation on Mutual Fund Investment by NRIs

Investing in Indian mutual funds offers numerous advantages to non-resident Indians (NRIs). With their familiarity with the Indian market, NRIs can make informed investment decisions, leveraging the country’s potential for attractive long-term returns across various sectors. Diversification is another crucial benefit, allowing NRIs to spread risk across different assets and markets. Additionally, Indian mutual funds are professionally managed, providing NRIs access to expert management without active oversight. Tax benefits under Section 80C and exemptions on long-term capital gains tax further enhance the attractiveness of these investments. The convenience of online investment platforms and the flexibility to invest, monitor, and redeem units from anywhere in the world add to the appeal.

Moreover, investing in Indian mutual funds allows NRIs to diversify their currency exposure and contribute to India’s economic growth and development. Indian mutual funds present NRIs with a compelling opportunity to build wealth and participate in India’s growth story; however, each NRI investment in mutual funds will have specific tax implications. This chapter covers the process of investing in mutual funds. It also explains the NRIs’ tax implications.

To invest in mutual funds in India, individuals should follow the prescribed procedure:

1. Open an NRO/NRE account: They must initiate the process by opening either an NRO (Non-Resident Ordinary) or NRE (Non-Resident External) account with an Indian bank. While an NRO account manages income earned in India, an NRE account facilitates the conversion of foreign currency earnings into Indian currency. It’s essential as Indian asset management firms do not accept investments in international currencies. Once they commence investing in a mutual fund scheme through an NRE/NRO account, they must maintain the same account type for that investment in that scheme. A mix of investment sources is prohibited (Please note: This restriction applies at the folio level).
2. KYC Compliance: Individuals must complete Know Your Customer (KYC) formalities before investing in India. They should provide passport-sized photographs and self-attested copies of relevant passport pages, address proof, and birth certificate. If required by the fund house or bank, they may need in-person verification, potentially involving visiting the Indian embassy in their resident country.
3. Qualifiers: They should be aware that certain mutual fund schemes in India may not be accessible to NRIs from the USA and Canada due to stringent FATCA (Foreign Account Tax Compliance Act) compliance procedures. Fund houses accepting NRI investments from these countries may request additional documentation and eligibility criteria.
   1. FATCA’s Reach: The Foreign Account Tax Compliance Act (FATCA) is a US law with an extensive reach, targeting US citizens and tax residents regardless of location. This means that Indian mutual funds dealing with US NRIs must comply with stricter FATCA regulations than other countries.
   2. Information Sharing: FATCA mandates Indian mutual funds to share specific financial information about US NRI investors with the US Internal Revenue Service (IRS). This involves additional verification processes and data collection, making the process more complex.
4. Challenges for Indian Mutual Funds:
   1. Compliance Burden: Meeting FATCA’s stringent verification and reporting requirements can be burdensome for Indian mutual funds, especially online transactions. This can lead to increased costs and administrative complexities.
   2. Potential Penalties: Non-compliance with FATCA can result in significant penalties for Indian mutual funds, including withholding taxes on US NRI investments. This creates a strong incentive for them to adhere to the regulations strictly.
5. Impact on Investment Options:
   1. Restricted Online Access: Due to the complexities of FATCA compliance, some Indian mutual funds may choose to limit online investment options for US NRIs. Online platforms might offer a lower level of security and transparency required for adhering to FATCA regulations.
   2. Offline Alternatives: Many Indian mutual funds still accept investments from US NRIs through offline methods (physical forms, applications, etc.). This allows for stricter verification and documentation, ensuring compliance with FATCA requirements.
6. Comparison with Other NRI Investors:
   1. Less Stringent Regulations: NRIs from other countries may face some regulations regarding investments in India, but these are generally less stringent than FATCA. They may involve reporting requirements or tax implications, but the focus is less intense than for US NRIs.
   2. Simpler Processes: For non-US NRI investors, the investment process is often more straightforward, with online options readily available in many cases. This is because the compliance burden for Indian mutual funds is significantly lower compared to dealing with FATCA regulations.
7. Therefore, the stricter focus on US tax compliance through FATCA significantly impacts the investment process for US NRIs in Indian mutual funds, making it more complex and potentially restricting online access compared to NRIs from other countries.
8. Investment mode: Investors can invest directly in a mutual fund online or through a designated Power of Attorney (PoA) in India.

The tax treatment of mutual funds differs for NRIs and resident Indians across several aspects, along with specific exemptions and benefits for NRIs:

Tax Deducted at Source (TDS):

1. NRIs are subjected to TDS upon redeeming mutual funds, with the specific rate determined by the scheme type (equity or non-equity) and the holding duration.
2. TDS is applied at the highest applicable rate, but NRIs in lower tax brackets may claim refunds when filing their ITRs. They may also apply for a NIL TDS certificate with the IT department of India to reduce or avoid the amount of TDS.

Capital Gains Tax:

1. The tax rate on capital gains from mutual funds depends on the scheme type and holding period.
2. Short-term capital gains from equity schemes are taxed at 15%, while long-term gains over Rs. 1 lakh incur a 10% tax without indexation benefit.
3. For non-equity schemes, short-term gains are taxed at 30%, and long-term gains are taxed at 20% with indexation.

Tax Filing Requirements:

1. NRIs aren’t obligated to file an income return if their earnings solely comprise investment income or long-term capital gains, provided appropriate TDS deductions have been made.
2. Filing returns can be advantageous, as NRIs in lower tax brackets may receive TDS deduction refunds.

Dividend Taxation:

1. Dividends from dividend schemes, whether equity or non-equity, are treated as yearly income and taxed according to the applicable slab rate.

Let us summarize the information we have seen above:

(Source: https://mf.nipponindiaim.com/mutualfundarticles/Pages/nri-investment-in-mutual-funds.aspx)

Tax Exemptions and Benefits for NRIs investing in mutual funds:

1. Section 80C Deductions: NRIs can claim deductions under Section 80C for investments in specified mutual fund schemes like Equity-Linked Savings Schemes (ELSS), up to Rs. 1.5 lakh.
2. Long-Term Capital Gains (LTCG) Exemption: Equity-oriented mutual funds enjoy a special exemption where LTCG exceeding Rs. 1 lakh in a financial year are taxed at 10% without indexation benefit. However, the first Rs. 1 lakh of LTCG is entirely tax-exempt.
3. Tax Residency Certificate (TRC): NRIs can obtain a TRC from their home country to avail of a lower TDS rate on mutual fund investments. The actual TDS rate depends on the TRC and the tax agreement between India and the NRI’s country of residence. Sometimes, this rate can be significantly lower, reducing the tax burden for NRIs. TRCs are a compulsory document that allows NRIs to take advantage of tax treaties between India and their home countries, which can help avoid double taxation and lower their overall tax bill on Indian investments.
4. No Tax Filing Required: NRIs are indeed not obligated to file an income tax return in India if their Indian income solely consists of:
   1. Investment Income includes dividends, interest earned on deposits, and rental income.
   2. Long-Term Capital Gains (LTCG): This applies to gains from selling equity-oriented mutual funds after holding them for over a year, where the first Rs. 1 lakh is tax exempted. The rest is taxed at 10% without indexation.
5. Conditions for Non-Filing: This exemption from filing applies only if:
   1. TDS Deductions: Appropriate TDS (Tax Deducted at Source) has been applied to the investment income or LTCG at the time of redemption. This ensures that some tax has already been paid upfront.
   2. Income Below Threshold: The total income from these sources is, at most, the basic exemption limit for NRIs, which is currently Rs. 2.5 lakh (as per the existing tax regime) or Rs. 3 lakh (as per the new tax regime).
6. Potential Benefits of Filing: Even though filing isn’t mandatory, there can be advantages to doing so in certain situations:
   1. Claiming Refunds: If the TDS deducted exceeds the actual tax liability based on the NRI’s income slab, filing a return allows them to claim a refund for the excess amount.
   2. Tax Benefits: NRIs can utilize tax benefits like deductions under Section 80C (investments in ELSS) by filing a return, potentially lowering their overall tax burden.
   3. Double Taxation Avoidance Agreement (DTAA): If the NRI’s country of residence has a DTAA with India, filing a return helps claim tax credits for taxes paid in India, preventing double taxation.
7. Therefore, while NRIs with limited Indian income might not be strictly required to file tax returns, doing so can offer benefits like claiming refunds, utilizing tax deductions, and maximizing benefits under DTAAs.
8. Tax Benefits Under DTAA: NRIs can leverage DTAA agreements, such as those with the US, to claim tax paid in India as a credit against their tax liability in their country of residence, potentially reducing their overall tax burden, thus avoiding double taxation. Double Taxation Avoidance Agreements (DTAA) are crucial in mitigating the tax burden for NRIs who have invested in mutual funds in India.
   1. Prevention of Double Taxation: One of the primary purposes of DTAA is to prevent double taxation of the same income in both the source country (where the income is generated) and the residence country (where the investor resides). In mutual fund investments, DTAA ensures that NRIs do not pay tax on the same income in India and their home country.
   2. Tax Credit Mechanism: DTAA typically provides a tax credit mechanism wherein NRIs can claim a credit in their home country for the taxes paid in India on their mutual fund investments. This means that NRIs can offset the taxes paid in India against their tax liability in their home country, effectively reducing their overall tax burden.
   3. Reduction of Withholding Tax Rates: DTAA often allows for lower withholding tax rates on various types of income, including dividends, interest, and capital gains from mutual fund investments. For example, suppose the withholding tax rate on capital gains in India is higher than the rate specified in the DTAA with the NRI’s home country. In that case, the lower rate prescribed by the DTAA will apply, reducing the tax outflow for the NRI.
   4. Exemption from Certain Taxes: Some DTAA provisions may exempt specific types of income, such as capital gains on certain investments, from taxation in the source country (India). NRIs can leverage these exemptions to reduce their tax liabilities on mutual fund investments, thereby enhancing their after-tax returns.
   5. Residency Status Determination: DTAA also helps determine the tax residency status of NRIs, which is crucial for determining their tax obligations in India and their home country. This clarity on residency status ensures that NRIs are taxed fairly and by the agreement’s provisions.
9. In summary, DTAA provides NRIs investing in mutual funds in India with various tax benefits, including the prevention of double taxation, tax credit mechanisms, reduced withholding tax rates, exemptions from certain taxes, and clarity on residency status. By leveraging the provisions of DTAA, NRIs can optimize their tax planning and minimize their overall tax liabilities on mutual fund investments.
10. NIL / Reduced TDS Certificate: A Nil Tax Deduction at Source (TDS) certificate is a document provided to Non-Resident Indians (NRIs) that enables them to minimize or eliminate TDS deduction on specific transactions or income sources in India. NRIs cannot use Form 15G/H, as residents might, to avoid TDS on their income. Instead, they must seek a Nil TDS certificate by applying to the assessing officer through Form 13 of income tax. NRIs can claim these if they fall in lower tax slabs than the TDS rate applied.
11. Essential Points about Nil TDS Certificate:
    1. Application Process: NRIs must apply online using Form 13 to request a Nil TDS certificate. The application requires verification through a Digital Signature Certificate (DSC) on the TRACES NRI website.
    2. Transaction Specific: The Nil TDS certificate applies to a particular transaction or income source specified by the NRI. For instance, if an NRI sells property or rents an Indian flat, they can apply for a Nil TDS certificate tailored to that transaction.
    3. Validity: The Nil TDS certificate remains valid for a designated period, typically until the end of the financial year (March 31), and only for the mentioned deductor or transaction.
    4. Role of Assessing Officer: After receiving Form 13, the TDS assessing officer reviews the application’s reasons and justifications provided by the applicant. The officer also assesses the TDS rate suggested by the income tax department’s software. The application may be rejected if the officer and the software agree on the existing TDS rate.
    5. Certificate Issuance: Upon approval of a lower or nil TDS rate, a certificate is issued detailing the specific TDS rate, the applicable timeframe, the Tax Deduction and Collection Account Number (TAN), and other pertinent details of the deductor or transaction.
12. In summary, a Nil TDS certificate empowers NRIs to manage their tax responsibilities in India by lessening or removing TDS deductions on particular transactions or income sources, offering them greater control over their tax obligations.

In Conclusion:

NRIs investing in Indian mutual funds should be aware of the challenges and opportunities related to taxation. While US NRIs might face complexities due to FATCA compliance, understanding the available exemptions and benefits can significantly impact their investment returns and tax liabilities.

Here’s a quick recap of the essential points:

• Tax Exemptions: Equity-oriented LTCG up to Rs. 1 lakh are tax-free. NRIs can claim lower TDS rates with a Tax Residency Certificate.
• Tax Benefits: Investing in ELSS schemes under Section 80C offers tax deductions, and DTAAs can help avoid double taxation.
• Filing Requirements: NRIs with limited Indian income might not need to file tax returns. However, doing so can provide benefits like claiming refunds or utilizing tax deductions.

By understanding these factors and seeking professional advice from specialize NRI Tax consultant, NRIs can make informed investment decisions and maximize their potential returns while minimizing their tax burden.