Centre scraps capital gains, interest tax on FII govt bond investments to pull foreign funds

Why in the News?

The Union Government promulgated the Income-tax (Amendment) Ordinance, 2026, which received President Droupadi Murmu’s assent on June 5, 2026. The ordinance completely exempts Foreign Institutional Investors (FIIs) from capital gains tax and withholding tax on interest income earned from Indian government securities, effective from April 1, 2026. The move seeks to attract large foreign debt inflows, address a projected $50-60 billion Balance of Payments (BoP) gap, and support rupee stability amid weak portfolio and FDI inflows.

How Has The Tax Treatment Of Foreign Investors Changed?

Previous Tax Regime

1. Long-Term Capital Gains Tax (LTCG): FIIs paid 12.5% tax on gains from bonds held for more than 12 months.
2. Short-Term Capital Gains Tax (STCG): FIIs paid 30% tax on short-term gains.
3. Withholding Tax: Foreign investors paid nearly 20% tax on interest income from government bonds.
4. Global Comparison: India’s withholding tax was among the highest globally after the concessional 5% rate expired in 2023.
5. Gross Taxation: Non-resident investors paid withholding tax on gross interest income and could not offset losses against past gains.

New Tax Regime

1. Capital Gains Exemption: The government has completely scrapped both Long-Term Capital Gains (LTCG) and Short-Term Capital Gains (STCG) taxes on investments made by FIIs in government bonds.
2. Interest Income Exemption: The government has also scrapped the withholding tax (Tax Deducted at Source) that FIIs were required to pay on their interest income derived from government debt instruments/bonds.
3. Coverage: Applies to investments through the General Route and Fully Accessible Route (FAR).
4. Effective Date: Changes become effective from April 1, 2026 following Presidential assent to the ordinance amending the Income Tax Act, 2025.
5. Institutional Coverage: Benefits extend to FIIs and the Bank for International Settlements (BIS).

Why Is India Seeking Greater Foreign Debt Inflows?

1. Balance of Payments Pressure
   1. BoP Deficit: India may face a $50-60 billion BoP deficit in FY27.
   2. External Financing Need: Sustained capital inflows are necessary to finance the deficit without exerting pressure on foreign exchange reserves.
2. Rupee Stability
   1. Exchange Rate Stress: The rupee had nearly breached the ₹97 per US dollar level recently.
   2. Recent Recovery: Rupee strengthened from ₹95.79/$ on Thursday to ₹94.94/$ on Friday.
   3. Currency Support: Higher debt inflows increase foreign exchange supply and support currency stability.
3. Weak Portfolio and FDI Flows
   1. Equity Outflows: FPIs have withdrawn approximately $28 billion from Indian equities in FY26.
   2. FDI Moderation: Net FDI inflows have weakened, increasing reliance on alternative capital sources.

How Large Could The Potential Foreign Inflows Be?

1. Expected Debt Inflows
   1. Axis Bank Estimate: Tax exemptions could attract $45-50 billion into government debt markets over the next two years.
   2. BoP Gap Financing: Such inflows could bridge a major portion of the projected external financing requirement.
2. Untapped Market Potential
   1. Current Holdings: FIIs hold only ₹3.75 lakh crore.
   2. Total Market Size: Government securities outstanding amount to ₹112.42 lakh crore.
   3. Foreign Share: Foreign participation remains limited at 3.34%.
3. Global Investor Appeal
   1. Tax Neutrality: Aligns India more closely with major sovereign bond markets.
   2. Yield Attraction: Indian government bonds offer relatively attractive yields compared to many developed markets.

What Additional Measures Have Been Taken To Liberalize Government Bond Investments?

1. Expansion Of Fully Accessible Route (FAR) Securities
   1. Coverage Expansion: RBI is considering inclusion of all new issuances of 15-year, 30-year and 40-year government bonds under FAR.
   2. Accessibility: Ensures unrestricted foreign investment in a larger segment of sovereign debt.
2. Removal Of Investment Restrictions
   1. Short-Term Investment Limits: Proposed removal of caps on short-duration investments.
   2. Concentration Limits: Removal of concentration restrictions on FII investments.
   3. Individual Security Limits: Greater flexibility for investors across government securities.
3. Complementary RBI Measures
   1. Overseas Borrowing: RBI eased norms for state-owned enterprises to borrow abroad.
   2. Foreign Currency Deposits: Banks allowed greater mobilization of foreign currency deposits.
   3. Objective: Strengthens overall foreign capital inflow architecture.

How Can Greater Debt Inflows Benefit The Indian Economy?

1. External Sector Stability
   1. BoP Financing: Ensures financing of current account and capital account gaps.
   2. Reserve Protection: Reduces pressure on foreign exchange reserves.
2. Rupee Appreciation
   1. Forex Supply: Higher inflows increase dollar availability.
   2. Exchange Rate Support: Reduces depreciation pressures on the rupee.
3. Bond Market Development
   1. Market Depth: Broadens investor base in government securities.
   2. Liquidity: Enhances trading activity and price discovery.
4. Lower Borrowing Costs
   1. Demand Expansion: Increased demand for government bonds may lower yields over time.
   2. Fiscal Benefit: Reduces government borrowing costs.
5. Global Financial Integration
   1. Market Confidence: Signals policy commitment to capital market reforms.
   2. International Participation: Improves India’s standing in global bond markets.

What Risks And Concerns Remain?

1. Dependence On Portfolio Flows
   1. Volatility Risk: Debt inflows can reverse quickly during global financial stress.
   2. External Vulnerability: Excessive reliance on foreign capital may increase exposure to global shocks.
2. Revenue Implications
   1. Tax Foregone: Government sacrifices tax revenues to attract foreign investment.
   2. Cost-Benefit Question: Actual inflows must justify revenue losses.
3. Monetary Management Challenges
   1. Liquidity Effects: Large inflows may complicate liquidity and exchange-rate management.
   2. Sterilization Costs: RBI may need intervention to manage excess forex inflows.
4. Structural Constraints
   1. Investment Decisions: Tax incentives alone may not overcome concerns relating to regulations, global risk appetite, and geopolitical uncertainties.

Conclusion

Amid global economic uncertainty and pressure on India’s external sector, the reform seeks to attract foreign capital, support the rupee, and deepen the sovereign debt market. It aligns with India’s broader aspiration of becoming a $5 trillion economy and a globally integrated financial powerhouse while ensuring macroeconomic stability.

PYQ Relevance

[UPSC 2016] Justify the need for FDI for the development of the Indian economy. Why is there a gap between MOUs signed and actual FDIs? Suggest remedial steps for increasing actual FDIs in India

Linkage: The PYQ examines policy measures undertaken by the government to attract foreign capital and strengthen investment inflows. The reform uses tax incentives to attract foreign capital and deepen India’s debt market.