Budget 2026: Tax transition India needs to shift to residence-based regime

The Budget should consider moving to a residence-based tax regime, exempting foreign investors from long-term capital gains tax

For years, our government has propelled the economy with its focus on infrastructure investments. However, for sustainable public debt and sustained capital formation, the investment baton must pass on to the private sector.  

This requires a conducive, competitive, and stable tax regime that treats capital as a partner, not a target. 

The quest for expertise 

When a global major invests in a semiconductor fab, an artificial intelligence (AI) data centre or electronics assembly under the Production Linked Incentive (PLI) scheme, it brings patented processes, integration into global supply chains, research and development, and other specialised skills that can drive future growth. Fostering investment, therefore, remains a top national priority. 

Global investment, particularly in AI, remains resilient. Yet, net foreign investm­ents into India have struggled. While gross foreign direct investment (FDI) in­fl­ows are robust, high repatriation has weakened net FDI. Net Foreign Portfolio Investment (FPI) flows have also disappointed. In a competitive global context, we aren’t giving capital enough reasons to stay.  

Despite manageable current account deficits by historical standards, weak net capital flows have also pressured India’s external balance. 

The withholding irritant 

While several issues impact foreign flows, the elephant in the tax office is the withholding tax on capital gains.  

Major jurisdictions adopt the Organisation of Economic Cooperation and Development-recommended residence-based taxation, under which any capital gains tax incidence arises only in the investor’s home jurisdiction. However, India follows source-based taxation. Despite treaties between India and other countries, many investors therefore see India as a taxation outlier, with legal uncertainties, upfront withholding, and friction in obtaining tax credits. 

Taxes withheld in India are a drag for investors exempt from capital gains taxes in their country. In other cases, FPIs struggle to get credit for Indian taxes because our withholding categories do not map onto their own tax credit regimes. Finally, computing gains in rupee terms amid rupee depreciation adds significantly to their drag. 

To compete for global savings and attract investment, the upcoming Budget should consider moving to a residence-based tax regime, exempting foreign investors from long-term capital gains (LTCG) tax in India.  

If such a blanket move were to raise fears of misuse by some, we could at least start with investors identified under the recently introduced SWAGAT-FI (Single Window Automatic and Generalised Access for Trusted Foreign Investors) framework.  Comprising objectively identified institutions like sovereign wealth funds and regulated public retail funds, SWAGAT-FI potentially covers over 70 per cent of FPI assets under management. While adding to complexity, such an approach could provide risk-based tax relief to major investors. 

The government could then consider a calibrated increase in the Securities Transaction Tax (STT) for some segments for revenue compensation, without penalising patient, long-term investors. The STT was originally designed as an alternative to LTCG tax.  

In the wake of the Tiger Global Supreme Court judgment, researchers Ajay Shah and Renuka Sane have also argued for a residence-based tax regime. Durably adopting this, in line with global best practice, should help attract and retain global savings. 

Asset-agnostic domestic reform 

Alongside, we must address issues faced by domestic investors. The current tax framework interferes with risk-based asset allocation. By taxing equity LTCG lower than fixed income, we are telling retirees: “Take more risk than your appetite allows, or watch inflation eat your principal.” 

Taxing interest without indexation is not an income tax – it is a wealth tax. For a senior citizen living on fixed income returns, a 6 per cent interest rate amid 5 per cent inflation yi­elds a 1 per cent real return. Taxing that 6 per cent interest at a 30 per cent slab rate leaves the investor with a negative real re­t­urn, even before expenses. Additionally, even when investing in fixed income, the investor bears market and credit risk, both crucial for capital formation. 

The solution is not to raise LTCG tax on equity — that would dampen investment — but to reduce fixed-income and other asset class LTCG taxes to equity levels. Indexation and risk-taking arguments justify lower, uniform LTCG taxes across asset classes, even if interest ex­pense is deductible at the borrower level. 

Furthermore, as in the US, introducing a 0 per cent tier for all LTCG across asset classes up to a reasonable threshold (say, ₹12 lakh, the current effective income tax-free limit), followed by the current 12.5 per cent tax tier, would encourage small savers and pensioners to invest in capital formation. 

Addressing the sceptics 

This is admittedly an involved and emotive subject. Critics can point to three issues: Fiscal considerations, inequity, and market volatility. 

First, with increased spending needs in education, skilling, and defence, every tax rupee counts. However, in the medium-term, a stable, investment-friendly tax regime as proposed should raise collections through increased activity, investment, and value addition. 

Second is the risk of inequity. One concern is the optics of appearing to offer foreigners LTCG ‘exemptions’ wh­ile taxing domestic investors. However, be­s­ides aligning with residence-based pri­nciples, foreigners would re­m­ain liable for taxes in their home jurisdictions; the issue would be one of comparing our LTCG regime with that of other nations. Then there is the optical in­equity of lower uniform LTCG tax versus higher income tax rates. Without indexation, however, higher LTCG tax effectively becomes a tax on wealth and risk-taking. We must reward investments. 

Finally, easing LTCG tax might prompt fears of short-term market volatility. In the medium run, however, rebalancing would ensure asset allocations mirror investor risk appetite rather than tax considerations. This should also channel more savings into fixed income and critical hybrid instruments like InvITs (Infrastructure Investment Trusts) and REITs (Real Estate Investment Trusts). 

The 2026 mandate 

To become a global economic superpower, we must stop seeing long-term investment primarily as a taxable event and start treating it as a crucial national resource. Shifting to a residence-based tax regime for foreign investors, and an asset-agnostic, risk-appreciative LTCG regime for domestic investors would be pro-investment, in line with global best practices, and would strengthen financial stability. For predictability, these underlying principles should be affirmed for the next decade.  This would stop us from hitting the brakes just as we look to press the investment accelerator.

 

The writer is a former whole-time member, Sebi. The views are personal