The India Provident Fund Regime U.S. Tax/Treaty Implication

The India Provident Fund Regime

In India, the Provident Fund (PF) system is very important for investment, retirement, and pension purposes. First, there is the Public Provident Fund (PPF), which is an investment instrument in India, in which the taxpayer can make contributions that grow tax-free through the time of distribution. Typically, the PPF grows for about 15 years before it reaches maturity. Next, is the EPF, which is the Employees Provident Fund. The EPF operates similarly to a 401K in which both the employer and employee make contributions to the scheme. While both terms refer to Provident funds, from a U.S. tax perspective the way each fund is taxed can be different. Let’s look at the basics of the different Indian provident funds.

What is a Public Provident Fund in India?

The Public Provident Fund is one of the most common types of investment schemes in India. It has been around for more than 50 years and is a form of long-term savings in which the taxpayer makes contributions annually to the fund and then once it reaches maturity, the taxpayer can receive distributions. One of the key benefits of the Public Provident Fund in India is that the government guarantees the investment in the fund and the interest rates are set by the government as well.  While the investment is usually for a 15-year term, it can be extended in 5-year allocations as well.

Is a Public Provident Fund Taxable in the U.S.?

Yes, under U.S. tax law since the Public Provident Fund is not a pension fund — even though it is often used as a retirement supplement — it is taxed as an investment. This is because the U.S. taxes Taxpayer income on a worldwide income basis. So, even if the investment is deferred under India Tax Law, under U.S. Tax Law, the income is taxable as accrued (even if it is not distributed). This can be confounding for owners of a PPF, for the simple fact that the investment is growing tax-free in India, but yet the income generated and not distributed is taxable in the United States. Thus, some taxpayers may want to (understandably) seek to avoid U.S. taxation of the growth in their Public Provident fund.

Can Taxes on the Public Provident Fund be Avoided?

Typically, if a US person who has investments in India such as a PPF wants to try to avoid U.S. tax on the income, there are two main ways to do so. If they are only a US person because they meet the Substantial Presence Test, then they can try to either avoid Substantial Presence or that is not an option they can try to show they have a closer connection with a foreign country or countries in order to avoid U.S. tax on their worldwide income, including the PPF.

Alternatively, if the taxpayer is considered a permanent resident of the United States and/or meets the substantial presence test but does not meet one of the exceptions/exclusions, then they can make a treaty election to try to be taxed as a foreign person. In order to make a treaty election, the resident would have to be residing in a foreign country that has entered into a tax treaty with the United States so that the taxpayer can file a Form 8833 in conjunction with 26 CFR 301.7701(b)-7 and then only pay U.S. tax on their U.S. sourced income (see below).

India Employees Provident Fund Pension (EPF)

Unlike the Public Provident fund, the Employees Provident fund is a pension plan like how pension plans are taxed in the United States. Noting, the rules have changed a bit over the past few years in India, and especially for taxpayers who are considered high-income earners and making large contributions, some of the portions of the contributions/growth are still taxable — which may have been not taxable in years past.

Generally, for a U.S. person, the key issue will be how EPF distributions are taxed to the U.S. Person. There are a few important factors when determining whether or not the pension is taxable, such as:

• • • Is the person a resident of the United States or a citizen of the United States?

    • Which country is a taxpayer located in when they’re receiving distributions?

    • If they only have US person status because they met the substantial presence test, do they qualify for an exception or exclusion to SPT?

    • If they live outside of the United States, do they qualify for a treaty election?

Public vs Private Pension

In general, in treaty countries such as India, if a pension is a public pension from public employment or government employment, then generally the distributions are only taxed by the country of source. Conversely, if the pension is a private pension, then generally it is taxed by the country of residence due to the saving clause and how the United States interprets tax law for pension distributions.

Important India Treaty Provisions

Here are two important treaty provisions for India and Provident Funds:

U.S./India Pension Article 20

• • • “Any pension, other than a pension referred to in Article 19 (Remuneration and Pensions in Respect of Government Service), or any annuity derived by a resident of a Contracting State from sources within the other Contracting State may be taxed only in the first-mentioned Contracting State.

    • “Notwithstanding paragraph 1, and subject to the provisions of Article 19 (Remuneration and Pensions in Respect of Government Service), social security benefits and other public pensions paid by a Contracting State to a resident of the other Contracting State or a citizen of the United States shall be taxable only in the first-mentioned State.”

    • The term “pension” means a periodic payment made in consideration of past services or by way or compensation for injuries received in the course of performance of services.

    • ‘The term “annuity” means stated sums payable periodically at stated times during life or during a specified or ascertainable number of years, under an obligation to make the payments in return for adequate and full consideration in money or money’s worth (but not for services rendered).”

    • ‘Alimony paid to a resident of a Contracting State shall be taxable only in that State. The term “alimony” as used in this paragraph means periodic payments made pursuant to a written separation agreement or a decree of divorce, separate maintenance, or compulsory support, which payments are taxable to the recipient under the laws of the State of which he is a resident.’

    • “Periodic payments for the support of a minor child made pursuant to a written separation agreement or a decree of divorce, separate maintenance or compulsory support, paid by a resident of a Contracting State to a resident of the other Contracting State, shall be taxable only in the first-mentioned State.”

Savings Clause and Exceptions

• • • “Notwithstanding any provision of the Convention except paragraph 4, a Contracting State may tax its residents (as determined under Article 4 (Residence)), and by reason of citizenship may tax its citizens, as if the Convention had not come into effect. For this purpose, the term “citizen” shall include a former citizen whose loss of citizenship had as one of its principal purposes the avoidance of tax, but only for a period of 10 years following such loss.”

    • “The provisions of paragraph 3 shall not affect (a) the benefits conferred by a Contracting State under paragraph 2 of Article 9 (Associated Enterprises), under paragraphs 2 and 6 of Article 20 (Private Pensions, Annuities, Alimony, and Child Support), and under Articles 25 (Relief from Double Taxation), 26 (Nondiscrimination), and 27 (Mutual Agreement Procedure); and (b) the benefits conferred by a Contracting State under Articles 19 (Remuneration and Pensions in Respect of Government Service), 21 (Payments Received by Students and Apprentices), 22 (Payments Received by Professors, Teachers and Research Scholars) and 29 (Diplomatic Agents and Consul Officers), upon individuals who are neither citizens of, nor have immigrant status in, that State.”

26 CFR § 301.7701(b)-7 – Coordination with income tax treaties.

• • • “Consistency requirement—

      • The application of this section shall be limited to an alien individual who is a dual resident taxpayer pursuant to a provision of a treaty that provides for resolution of conflicting claims of residence by the United States and its treaty partner. A “dual resident taxpayer” is an individual who is considered a resident of the United States pursuant to the internal laws of the United States and also a resident of a treaty country pursuant to the treaty partner’s internal laws.

      • If the alien individual determines that he or she is a resident of the foreign country for treaty purposes, and the alien individual claims a treaty benefit (as a nonresident of the United States) so as to reduce the individual’s United States income tax liability with respect to any item of income covered by an applicable tax convention during a taxable year in which the individual was considered a dual resident taxpayer, then that individual shall be treated as a nonresident alien of the United States for purposes of computing that individual’s United States income tax liability under the provisions of the Internal Revenue Code and the regulations thereunder (including the withholding provisions of section 1441 and the regulations under that section in cases in which the dual resident taxpayer is the recipient of income subject to withholding) with respect to that portion of the taxable year the individual was considered a dual resident taxpayer.”

Form 8833 (Election)

• • • Form 8833 must be used by taxpayers to make the treaty-based return position disclosure required by section 6114 and the regulations thereunder (Regulations section 301.6114-1). The form must also be used by dual-resident taxpayers (defined later) to make the treaty-based return position disclosure required by Regulations section 301.7701(b)-7. A separate form is required annually for each treaty-based return position taken by the taxpayer, although a taxpayer may treat payments or income items of the same type received from the same payor as a single item for reporting purposes.

The Individual is a Dual-Resident Taxpayer

• • • “If that individual is considered to be a resident of both the United States and another country under each country’s tax laws. If the income tax treaty between the United States and the other country contains a provision for resolution of conflicting claims of residence by the United States and its treaty partner, and the individual determines that under those provisions he or she is a resident of the foreign country for treaty purposes, the individual may claim treaty benefits as a resident of that foreign country, provided that he or she complies with the instructions below.

    • If you are an individual who is a dual-resident taxpayer and you choose to claim treaty benefits as a resident of the foreign country, you are treated as a nonresident alien in figuring your U.S. income tax liability for the part of the tax year you are considered a dual-resident taxpayer. If you are eligible to be treated as a resident of the foreign country pursuant to the applicable income tax treaty and you choose to claim benefits as a resident of such foreign country, you must file Form 1040-NR, U.S. Nonresident Alien Income Tax Return, with Form 8833 attached.”

Interest and Dividends (PPF)

• When it comes to Provident Funds and interest/dividends, the general treaty rules are as follows:

  • • “Dividends paid by a company which is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other State.

    • Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.”

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