Foreign investors to get tax break in govt bonds. What does it mean for India?

Foreign investors have withdrawn nearly $28 billion from Indian equities this year. While foreign money has continued to flow into government bonds, with net investments of around $1.4 billion, policymakers appear keen to attract more stable capital into the debt market.

In Short

• Foreign investors currently pay 12.5% long-term tax on listed bonds
• Government may also remove 20% withholding tax on bond interest
• Higher post-tax returns could lift demand and soften government borrowing costs

The government has decided to remove capital gains tax on foreign investors investing in government bonds. Sources told India Today that the proposal was cleared by the Union Cabinet.

The move comes at a time when India is trying to counter pressure on the rupee, which has weakened more than 5% since the start of the year due to rising oil prices and heavy foreign outflows from equities.

While the tax relief may sound technical, its impact could extend beyond foreign investors. It could influence government borrowing costs, bond yields, capital flows and even the stability of the rupee.

WHY IS INDIA CONSIDERING THIS MOVE?

The timing is not accidental.

Foreign investors have withdrawn nearly $28 billion from Indian equities this year. While foreign money has continued to flow into government bonds, with net investments of around $1.4 billion, policymakers appear keen to attract more stable capital into the debt market.

The government is also looking to strengthen the rupee by encouraging fresh foreign inflows. More foreign money entering Indian bonds would increase demand for rupee-denominated assets, potentially offering support to the currency.

India is among the few countries that continue to tax non-resident investments in debt markets, making Indian bonds relatively less attractive compared to many competing markets.

WHAT CHANGES FOR FOREIGN INVESTORS?

At present, foreign investors are subject to a 12.5% long-term capital gains tax on listed bonds held for more than 12 months.

The government may remove the 20% withholding tax that foreign investors currently pay on interest income earned from government bonds.

If both changes are implemented, foreign investors would retain a larger share of their returns from Indian government securities.

In simple terms, the same bond investment would become more profitable after tax.

WHY THE BOND MARKET COULD BENEFIT

Higher post-tax returns often attract more investors.

If overseas investors increase their purchases of Indian government securities, demand for bonds could rise. When demand rises, bond yields generally fall.

Lower bond yields can be beneficial for the government because they reduce borrowing costs.

Every year, the government borrows large sums from the market to fund expenditure and manage fiscal requirements. Even a small reduction in borrowing costs can translate into significant savings over time.

Dr Manoranjan Sharma, Chief Economist at Infomerics Ratings, said eliminating capital gains tax on FPIs' investments in government bonds could boost foreign demand for Indian government securities and improve after-tax returns.

He said the move could deepen India's bond market and help lower government borrowing costs while bringing India's tax regime closer to global standards.

WHAT IT COULD MEAN FOR THE RUPEE

One of the biggest challenges facing policymakers this year has been pressure on the rupee.

Rupee has weakened more than 5% since January, affected by rising crude oil prices and foreign portfolio outflows.

More foreign investment into government bonds could help improve capital inflows and support the currency.

A stronger or more stable rupee can have wider benefits for the economy. It can help control imported inflation, reduce pressure on foreign exchange reserves and improve investor confidence.

However, economists caution that tax reforms alone cannot solve all currency-related challenges.

Madhavi Arora, Chief Economist at Emkay Global Financial Services, told Reuters that the move could help improve flows at the margin but is not a "magic bullet" in the current environment.

Oil prices, global interest rates, geopolitical developments and overall investor sentiment will continue to influence foreign capital flows.

ARE THERE ANY RISKS?

While the proposal has attracted support, it is not without concerns.

Dr Sharma noted that removing capital gains tax would result in revenue loss for the government.

He also pointed out that the move could raise questions about whether foreign investors are being given preferential treatment compared to domestic investors who continue to pay taxes on similar investments.

Another concern is the possibility of tax arbitrage, where investors structure transactions primarily to take advantage of tax benefits rather than for genuine investment purposes.

To address these concerns, Sharma suggested a calibrated approach that could include limited exemptions for specified sovereign bonds along with strong anti-avoidance safeguards.

WILL IT LEAD TO A FLOOD OF FOREIGN MONEY?

That remains uncertain.

While the tax changes could make Indian government bonds more attractive, investment decisions are influenced by many factors beyond taxation.

Foreign investors will continue to evaluate India's economic growth prospects, fiscal position, currency stability and global market conditions before increasing allocations.

Nevertheless, the proposal sends a clear signal that India wants to become a more attractive destination for global debt investors.

The proposed tax relief is about more than just helping foreign investors.

It is part of a broader effort to deepen India's bond market, attract long-term foreign capital and reduce pressure on the rupee at a time of global uncertainty.

If implemented carefully, the move could help improve foreign participation in government bonds, lower borrowing costs and strengthen India's position in global debt markets.

The challenge for policymakers will be balancing those benefits with concerns around tax fairness, revenue loss and the need to ensure that domestic investors are not placed at a disadvantage.

(Disclaimer: The views, opinions, recommendations, and suggestions expressed by experts/brokerages in this article are their own and do not reflect the views of the India Today Group. It is advisable to consult a qualified broker or financial advisor before making any actual investment or trading choices.)

- Ends