As capital outflows have erased nearly $38 billion from India’s foreign exchange reserves since tensions in West Asia escalated, reports suggest that the government is weighing a cut in the withholding tax rate on bonds from 20% back down to 5% to attract foreign portfolio investors (FPIs). However, while experts are positive on the move, they do not believe a tax reduction alone would be enough to bring meaningful inflows back into Indian debt markets.
Most market participants argue that while lower taxes may improve India’s long-term appeal, foreign investors remain far more concerned about the weakening rupee, rising global bond yields and elevated oil prices.
The tax problem
According to an industry expert, India’s taxation framework for foreign investors has long been out of step with global markets.
“Foreign investors pay tax on all capital gains made in India. India is different from all major economies which follow residence-based taxation, meaning capital gains are taxed in the country of your residence, not the country in which you invest,” he said on the social media platform X, formerly Twitter.
He pointed out that FPIs investing in Indian bonds are taxed on capital gains when bond prices rise due to falling interest rates. The issue becomes especially complicated for passive funds tracking global bond indices, since taxes deducted in India directly eat into returns.
“The FPI may be an index fund buying a bond index in which Indian securities are included, and they will underperform that index because the tax is deducted in India at source,” he said.
He also highlighted the complexity around accrued interest taxation in the secondary bond market. Foreign investors buying bonds between coupon payment dates pay accrued interest upfront, but even that component can end up attracting tax deductions.
“Even if there’s only a 5% tax on interest, I think the TDS is 20%, which sucks double big time because you have to wait about a year to get a refund,” he said. According to him, India should move towards eliminating capital gains taxes on listed bonds for FPIs entirely, while reducing withholding tax on interest income to 5% or lower.
Still, he cautioned that such measures are unlikely to immediately reverse foreign outflows. “It won’t reverse FPI flows really, but in the long term it will attract foreign capital and allow the rupee to internationalise,” he added.
No short-term changes likely
That long-term versus short-term divide was echoed by the Head of Research at Emkay Wealth Management, who said that reducing withholding tax “by itself is not going to bring in any funds into India.” According to Thomas, the biggest deterrent right now is currency depreciation.
“The Indian Rupee is continuously weakening, and it is expected to weaken further despite RBI intervention,” he said. “If overseas investors come in, they will be at a loss from day one because they are investing in a currency which is weakening.”
The rupee recently crossed the 96-per-dollar mark, intensifying concerns over returns being eroded by currency movements. Thomas said overseas investors first need confidence that the rupee has stabilised before they can meaningfully assess bond returns. “Whether it is 96 or 98 or 100, it needs to stabilise somewhere before overseas investors can come into India,” he said.
He also pointed to rising bond yields as another challenge. India’s 10-year benchmark bond yield has been inching up amid inflation concerns driven by elevated crude oil prices and rupee weakness.
“With high oil prices and a weak rupee, inflationary pressures will increase. In such a scenario, interest rates cannot come down. On the contrary, RBI could hike rates and yields will go up,” he said.
Another factor weighing on bond markets is the government’s large borrowing programme. Combined gross borrowing by the Centre and states this financial year is estimated at nearly Rs 27 lakh crore, increasing supply pressure in the market.
“These factors will continue to put pressure on bond markets. Therefore, bond yields are going to rise,” he said. “If investors buy at current yields and yields move higher, they start making losses.” However, he added that if the rupee were to stabilise around current levels, the tax cut could become significantly more meaningful.
“If the rupee stabilises, 50% of the problem is overcome,” he said, adding that investors may then start looking at shorter-duration government securities where valuations appear more attractive.
Proposed reforms for bringing back FPIs
Co-founder of IndiaBonds.com, also described the proposed tax rollback as a positive structural move, but said global macro conditions continue to dominate investor decisions. “I think it is a good long-term measure, but will it have any short-term impact? I really doubt it because the global factors are outplaying any singular factor that can affect or reverse bond inflows into the country,” Goenka said.
He noted that elevated US bond yields continue to pull global capital back into developed markets, reducing the attractiveness of emerging market debt. “If I’m getting 4.6% in the US 10-year bond and 7.1% in India, that’s a 250 basis point differential. But if the currency depreciates by 10-12%, then I’m going to lose money investing in India,” he explained.
He added that persistently high oil prices would likely keep pressure on India’s currency and inflation trajectory for several months, limiting the effectiveness of a tax cut in the near term. At the same time, he argued that India needs broader structural reforms to deepen its bond markets and improve liquidity.
“Tax is one aspect, but the other aspect could be structural reforms and ease of doing business around reporting and processes,” he said. He also suggested rationalising taxation on bond interest income for domestic investors to improve market liquidity. “Your market becomes attractive when the underlying market is liquid,” he said. “Tax equalisation between bonds and equities could help boost domestic demand and also attract foreign investors.”
Focus on equity, not debt?
Another industry expert, said the proposed tax changes may improve sentiment marginally, but are unlikely to materially alter the broader FPI stance towards India. “It is important to understand that the real problem is sustained FPI selling in equity and not in debt,” he said.
He noted that FPIs held around $713 billion in Indian equities at the start of May, compared with only $65 billion across all debt categories, making equity flows the more important driver of overall foreign investor sentiment.
According to him, equity outflows continue to be driven by the global AI trade, stronger earnings growth opportunities in other markets, rupee depreciation and rising US bond yields. “A change in FPI stance towards India would require changes in some of these factors,” he said.
