You check your Indian mutual fund statement and it shows a gain, but you have not sold a single unit. Yet your tax preparer tells you that you owe US tax on that fund this year.
This confuses almost every NRI who holds Indian mutual funds while living in the US, since capital gains tax on a US brokerage account only starts when you sell, but Indian mutual funds fall under a different regime entirely, the passive foreign investment company (PFIC) rules.
Today, I will explain why that happens, what the default PFIC regime does, how the mark to market election changes the picture, and when your funds can sit at zero tax while you hold them.
Why you owe tax before you sell anything
The mistake most people make is assuming PFIC tax works like ordinary capital gains tax, where a sale is the only event that matters. It is not. Under IRC Section 1291, the default PFIC regime, tax is triggered by either a disposition or a distribution, and a distribution does not require you to do anything.
Many Indian mutual funds, especially older schemes and dividend option funds, distribute realized capital gains to unit holders as a matter of course. If that distribution exceeds 125 percent of the average distributions you received over the prior 3 years (or your full holding period if shorter), the excess counts as an excess distribution under Section 1291. You never sold, but the fund made a decision that triggered the tax anyway.
This is one of the most common misconceptions in PFIC compliance. Believing that "the rules don't apply because I haven't sold" is flatly wrong for excess distributions, and it is the single biggest reason NRIs get surprised by a PFIC bill.
Is your mutual fund actually a PFIC
Almost certainly, yes. A foreign corporation is a PFIC under IRC Section 1297 if 75 percent or more of its gross income is passive (dividends, interest, capital gains) or if 50 percent or more of its assets produce passive income. Indian equity funds, debt funds, hybrid funds, and ELSS schemes all meet this test, because their income is dividends and capital gains by design.
If you want the full walkthrough of how the classification test works and which India-specific products qualify, what counts as a PFIC covers that in detail. For this article, treat it as settled: your Indian mutual fund is a PFIC, and the only open question is which of the three tax treatment methods applies to it.
The Section 1291 default: how gains get taxed without a sale
Section 1291 is not something you elect into. It is what applies automatically the moment you own a PFIC and have not made a QEF or mark to market election. That is why it catches so many NRIs off guard, nobody signed up for it, it is simply the fallback.
Here is the mechanic. When a Section 1291 trigger event happens, whether an excess distribution or an actual sale, the gain is not taxed at your current year's rate. Instead, it gets allocated ratably across every day you held the fund.
The portion allocated to each prior year is taxed at the highest individual marginal rate that applied in that specific year, not your actual bracket that year. For years before 2018 that rate is 39.6 percent. For 2018 onward it is 37 percent, under IRC Section 1291(c)(2).
On top of that, the IRS charges underpayment interest under IRC Section 6621 on each prior year's allocated tax, running from roughly the midpoint of that year to the date you actually pay. Hold a fund for six years before a trigger event and you are paying six years of compounding interest along with six years of tax at the top rate, regardless of what your real income looked like in any of those years. The IRS instructions for Form 8621 walk through this allocation method line by line if you want the underlying detail.
Consider Meera, who bought units in an Indian equity fund in 2019 and never sold. In 2025 the fund made a large capital gains distribution that exceeded the 125 percent threshold.
The excess portion gets spread across 2019 through 2025, each year's slice taxed at 37 percent, plus interest accruing on the 2019 through 2024 slices. Meera's actual income in those years, some of it modest US resident income, does not matter to this calculation.
If you want to move off the default regime, weighing QEF against mark to market walks through the full decision. And regardless of which regime applies, the Form 8621 filing steps are the same paperwork you file every year per fund.
| Section 1291 (default) | Mark-to-Market (Section 1296) | |
|---|---|---|
| What triggers tax | Excess distribution or disposition (sale) | Nothing. Taxed automatically at each year-end. |
| Rate applied | Highest marginal tax rate for each prior year (37% from 2018 onward) | Your ordinary income tax rate in the current year |
| Interest charge | Yes. IRC Section 6621 underpayment interest applies to prior years. | No |
| Predictability | Low. Tax may be zero for years and then arrive as one large lump-sum liability. | High. You recognize gains annually, making tax more predictable. |
| Best suited for | Growth-option funds with no distributions and no near-term sale plans | Funds with regular appreciation where you prefer to recognize gains annually |
Mark to market: paying tax on paper gains on purpose
The mark to market election under Section 1296 flips the default on its head. Instead of waiting for a trigger event and then facing a punitive lookback, you agree to pay tax on your unrealized gain every single year, calculated as the difference between the fund's value on December 31 this year and December 31 last year. That gain is taxed as ordinary income, and losses are deductible, but only up to the amount of gains you have previously recognized under the election.
The catch is eligibility. Section 1296 requires the PFIC stock to be "marketable," meaning it trades regularly on a qualified exchange under 26 CFR 1.1296-2. Indian mutual funds you buy directly from an AMC do not qualify, since they are purchased and redeemed through the fund house, not traded on an exchange.
India ETFs listed on the NSE or BSE are a different story. Since NSE and BSE are regulated by SEBI, a governmental securities authority, many practitioners treat them as meeting the qualified exchange test, though the IRS has not published a formal approved list, so some technical risk remains.
The third option, the QEF election under Section 1295, is worth ruling out quickly. It requires the fund itself to issue a PFIC Annual Information Statement computed under US tax principles, and no Indian AMC does this. QEF is not a realistic option for Indian mutual funds today.
Switching into mark to market from the default regime usually means a purging election, a deemed sale of your existing position to reset your basis before the annual mark to market treatment begins. The mechanics of that reset, and what it costs based on your actual holding period, are covered in the first year cost basis reset guide.
The growth fund strategy: why some NRIs pay zero today
Here is the part that surprises people in the other direction. If your Indian mutual funds are in growth option, meaning all gains are reinvested and nothing gets distributed, you can genuinely owe zero PFIC tax while you hold them.
No distribution means no excess distribution trigger. No sale means no disposition trigger. Since Section 1291 tax only fires on one of those two events, a growth option fund that pays out nothing and gets sold to nobody produces a Section 1291 tax bill of exactly zero, year after year.
This is not a loophole you are exploiting, it is simply how the default regime behaves when neither trigger condition is met. It is a legitimate reason many NRIs choose to stay on the default rather than elect mark to market, particularly if they plan to return to India and stop being a US tax person before they ever sell.
Two things to hold onto here. First, the zero tax outcome does not remove your filing obligation. Under IRC Section 1298(f), you still file Form 8621 Part I for every PFIC you own every year, even when the tax owed is nothing.
Second, and this matters more, failing to file Form 8621 when required suspends the statute of limitations on your entire tax return indefinitely under IRC Section 6501(c)(8). The IRS can come back and assess years later with no expiration.
A narrow filing threshold exception exists if your total PFIC holdings stay under 25,000 dollars single or 50,000 dollars filing jointly with no distributions, gains, or elections, but most NRI mutual fund portfolios exceed that.
What changes if you sell or move back to India
Selling any of your units, even a partial redemption, is a disposition under Section 1291 and pulls in the same holding period allocation and lookback rates described above. There is no way around that mechanic once a sale happens.
Moving back to India and ceasing to be a US tax resident ends your Section 1291 exposure on future sales, since the regime only applies to US persons. Whether it makes sense to sell before or after that transition depends on your specific timeline and is worth planning around deliberately rather than reacting to.
Conclusion
The tax you are seeing is not really about whether you sold. It is about which PFIC regime applies to your specific funds and whether a trigger event, a distribution or a disposition, happened this year.
Once you know which regime you are on and whether your funds are growth or dividend option, the surprise mostly goes away. If you want a second set of eyes on your current fund lineup and PFIC filing history, we are glad to walk through it with you.
Frequently asked questions
Why do I have capital gains if I didn't sell anything?
Because the PFIC default regime, Section 1291, taxes excess distributions as well as sales. If your fund distributes realized gains above 125 percent of your 3 year average, that counts as a taxable event even with zero units sold.
Can a mutual fund be considered a PFIC?
Yes. Under IRC Section 1297, a fund is a PFIC if 75 percent or more of its income is passive or 50 percent or more of its assets produce passive income. Nearly every Indian equity, debt, and hybrid mutual fund meets this test.
How to avoid PFIC investments?
You cannot avoid the PFIC classification of an Indian mutual fund once you hold it, but you can manage the tax outcome. Growth option funds with no distributions and no sales can sit at zero Section 1291 tax, while the mark to market election trades that uncertainty for a predictable annual number.
What happens if I never filed Form 8621 for a PFIC?
There is no fixed dollar penalty for a missing Form 8621, but the PFIC penalty for late or missed filings is more serious in practice, since it keeps the statute of limitations open on your entire return indefinitely under IRC Section 6501(c)(8).
Do dividend reinvestments count as a sale for PFIC purposes?
Automatic reinvestment inside a growth option fund is not a distribution to you and not a disposition, so it does not trigger Section 1291 tax on its own. A fund that distributes cash and then you reinvest it manually is a different situation, since the distribution itself already happened.