India's bond market likely to get a tax makover to attract foreign capital

India may scrap capital gains tax on foreign investments in government bonds to boost capital inflows

The Centre is reportedly preparing to scrap capital gains tax on foreign portfolio investors (FPIs) investing in government securities, a move that could significantly boost overseas participation in India's debt market while helping cushion the economy from geopolitical and currency-related shocks.

 

According to a report in the Economic Times, the Union Cabinet has approved an ordinance to amend the Income Tax Act and exempt FPIs from capital gains tax on government bond investments. The proposal now awaits presidential assent before a formal notification is issued. Reuters separately reported that the move is aimed at attracting foreign capital and supporting the rupee amid economic uncertainty stemming from the conflict involving Iran and elevated global energy prices.

 

 

The proposed exemption would remove a long-standing irritant for global investors. Currently, FPIs pay a 12.5 per cent long-term capital gains tax on listed bonds held for more than 12 months. They are also subject to a 20 per cent withholding tax on interest earned from government securities after the withdrawal of the concessional tax regime in 2023.

 

Foreign portfolio flows have come under pressure this year, while the rupee has faced bouts of weakness. Reuters reported that the currency has fallen more than 5 per cent against the dollar this year, while foreign investors have pulled nearly $28 billion from Indian equities. At the same time, overseas investors have continued to add exposure to government debt, investing a net $1.4 billion so far this year.

 

Market participants see the proposal as part of a broader effort to make Indian debt markets more competitive globally.

 

"Scrapping the capital gains tax on FPI investments in Indian government bonds is a welcome and forward-looking measure. The removal of the 12.5 per cent capital gains tax substantially reduces the cost of investment for foreign portfolio investors and is expected to significantly boost foreign inflows into Indian government securities," said S.R. Patnaik, Partner and Head-Taxation at Cyril Amarchand Mangaldas.

 

Diviay Chadha, Partner at Singhania & Co., said the move could be transformative for India's debt markets. "For years, tax friction has made foreign funds think twice before choosing Indian bonds over other emerging markets. Cutting or removing this tax could trigger a wave of FPI inflows, inject much-needed liquidity into the bond market, and give the rupee a solid boost."

 

The reform also aligns with India's broader ambition of integrating its debt market with global capital pools. Over the past few years, the government and the Reserve Bank of India have introduced the Fully Accessible Route (FAR) and eased investment restrictions, helping Indian government securities gain inclusion in major global bond indices such as the J.P. Morgan Emerging Market Bond Index and Bloomberg's emerging market local currency bond index.

 

Tax treatment has remained one of the last significant hurdles for foreign investors evaluating Indian debt against competing emerging-market opportunities.

 

The proposed tax relief could therefore have implications beyond immediate capital flows. Greater foreign participation would deepen liquidity, diversify the investor base beyond domestic banks, improve price discovery and potentially lower borrowing costs for the government over time.

 

There are, however, questions around the fiscal cost of the measure. While the government would forego some tax revenue, policymakers appear to be betting that stronger capital inflows, a more stable currency and a deeper bond market will outweigh the near-term revenue sacrifice.  "Exempting FPI holdings in government securities from capital gains tax goes straight to foreign investors' oldest grievance, that India is one of the few markets that taxes non-residents on sovereign debt flows.  By lifting post-tax yields, it makes Indian G-Secs structurally more competitive against peer emerging markets and should help deepen a bond market still dominated by banks. The decisive detail, though, will be in the ordinance: whether the relief extends to the 20% withholding tax on interest, and how eligible instruments and investors are defined. Until the notification follows Presidential assent, this is directional, not yet law," said Vipin Upadhyay, Partner, King Stubb & Kasiva, Advocates and Attorneys.