Decoding complex US Tax compliance for Indian AIFs

Indian Alternative Investment Funds (AIFs) have emerged as an attractive investment option for US investors seeking exposure to India's burgeoning economy and diversified asset classes. However, these investments have intricate US tax compliance requirements that AIFs must address to help US investors meet their reporting obligations.

Proper coordination between Indian and US tax frameworks is not just a regulatory necessity but also a way to enhance investor confidence and satisfaction. This article explores the key elements of US tax compliance for Indian AIFs catering to US investors, the potential consequences of non-compliance, and best practices to manage these obligations efficiently.

1. Entity classification: The foundation of compliance

One of the most critical steps for an AIF serving US investors is determining its entity classification under US tax law. This decision significantly impacts how the fund's income, expenses, and tax attributes flow to investors.

Under US tax rules, foreign entities can elect to be treated as pass-through entities (e.g., partnership) or corporations for tax purposes. This classification is done through the Internal Revenue Services (IRS)'s “check-the-box” election process. If no option is elected, default classification rules apply, which may not always align with the AIF's operational and tax goals.

A pass-through classification is often preferred because it allows income to retain its character as it flows through to investors. For example, capital gains earned by the AIF would be treated as capital gains at the investor level, while dividends or interest income would retain their respective characterisations. This approach avoids double taxation and ensures that US investors receive tax-efficient treatment of their income.

Failing to elect a proper entity classification can result in the AIF being treated as a corporation, potentially triggering additional layers of tax and reducing investor returns.

2. Getting an employer identification number (EIN): A critical first step

For effective compliance with US tax laws, the AIF must obtain an employer identification number (EIN) from the IRS. This EIN serves as the fund's tax identification number and is crucial for several reporting requirements, including filing necessary US tax forms and issuing proforma Schedules K-1 and K-3 to US investors.

Schedules K-1 and K-3 are vital documents that provide US investors with detailed information about their share of the fund's income, deductions, and foreign tax credits. These schedules simplify the reporting process, ensuring that investors can accurately include the AIF's income in their personal tax returns while avoiding double taxation using foreign tax credits.

Without an EIN and accurate reporting, US investors may face significant challenges in complying with their tax obligations, potentially resulting in penalties or audits.

3. Passive foreign investment companies (PFICs): A complex tax trap

A significant compliance challenge arises when AIFs hold investments in passive foreign investment companies (PFICs). A PFIC is defined as a foreign corporation that meets one of the following criteria:

• Income test: At least 75% of its gross income is passive income (e.g., interest, dividends)
• Asset test: At least 50% of assets produced or are held for the production of passive income

For US investors, owning shares in a PFIC can result in punitive tax treatment, including:

• Excessive tax rates: Gains on PFIC investments are taxed at the highest ordinary income tax rate, rather than the lower capital gains rate
• Interest charges: US investors may face retroactive interest charges on deferred tax liabilities
• Complex reporting: Investors must file Form 8621 annually to report their PFIC holdings, a process that can be both time-consuming and costly.

To mitigate these consequences, the AIF must provide sufficient information to allow US investors to make a Qualified Electing Fund (QEF) election or apply the mark-to-market method. These elections help investors avoid punitive tax rates and streamline their reporting obligations. Without proper disclosures, investors may face unforeseen tax liabilities and compliance challenges.

4. Controlled foreign corporations (CFCs): Managing subpart F and GILTI income

Additional compliance challenges arise if an AIF's portfolio includes investments in controlled foreign corporations (CFCs). A foreign corporation is classified as a CFC if US shareholders (owning 10% or more of the voting power or value) collectively own more than 50% of the entity.

US investors in a CFC may be required to include two types of income in their tax returns, even if the fund does not distribute earnings:

• Subpart F income: This includes passive income like interest, dividends, and royalties.
• Global intangible low-taxed income (GILTI): This represents CFC profits that exceed a 10% return on tangible assets.

To help investors navigate these obligations, the AIF must evaluate its portfolio for CFC status and provide detailed information about any Subpart F or GILTI income. Failing to do so can lead to reporting errors, penalties and dissatisfied investors.

5. FATCA and CRS: Ensuring global transparency

Indian AIFs accepting US investors must also comply with international reporting standards under the Foreign Account Tax Compliance Act (FATCA) and the Common Reporting Standard (CRS).

Under FATCA, AIFs are required to identify and report information about US investors to Indian tax authorities, which then share this information with the IRS. Non-compliance with FATCA can result in:

• Withholding taxes of 30% on certain US-sourced payments.
• Reputational damage that could deter future US investments.

Similarly, compliance with CRS requires Indian AIFs to identify and report the tax residency of investors to the Indian tax authorities. These global transparency initiatives underscore the importance of robust compliance procedures for AIFs.

Cost of non-compliance: 

Failing to address US tax compliance obligations can have severe consequences for AIFs and their investors, including:

• Penalties and interest: US investors may face penalties for late or incorrect filings, while the AIF could be subject to sanctions under FATCA.
• Investor dissatisfaction: Inadequate reporting can lead to frustration among US investors, potentially impacting the AIF's reputation and ability to attract future investments.
• Operational disruptions: Non-compliance can result in audits or investigations, diverting resources away from the AIF’s core operations.

Best practices for Indian AIFs

To navigate the complexities of US tax compliance, Indian AIFs should adopt the following best practices:

• Obtain an EIN: Facilitate timely and accurate reporting
• Make the proper entity classification election: Consult US tax experts to determine the optimal classification for the fund
• Provide comprehensive disclosures: Ensure that US investors have the necessary information to comply with PFIC and CFC rules
• Maintain robust compliance procedures: Implement systems to meet FATCA and CRS reporting obligations
• Engage tax professionals: Partner with experts in US and Indian tax laws to streamline compliance and address investor concerns proactively

Our US Tax team experts

In the competitive realm of cross-border investing, proper planning, transparent reporting, and strict adherence to global tax standards are not merely obligations — they are critical strategies for success.

With expert guidance from Grant Thornton Bharat — US Tax team, Indian AIFs can unlock their full potential and build long-term trust with US investors.

Conclusion

Catering to US investors presents both an opportunity and a challenge to Indian AIFs. By addressing these complex tax compliance requirements, AIFs can enhance their appeal to US investors while ensuring operational efficiency and regulatory compliance.