Tax Exemption on FII Investments in Government Bonds

FII Investments Latest News

• The Union Government has exempted Foreign Institutional Investors (FIIs) from capital gains tax and interest income tax on investments in Indian government bonds to attract foreign capital inflows.

Foreign Investment in Government Bonds

• Government bonds are debt securities issued by the Central Government to finance its expenditure and borrowing requirements. 
• These securities are considered among the safest investment instruments because they carry sovereign backing.
• Foreign investors participate in India’s government bond market through regulated channels that allow overseas capital to invest in domestic debt instruments.

Routes for Foreign Investment

• Foreign investors can invest in Indian government securities through two major routes:
• General Route
  • Subject to investment limits and regulatory restrictions. 
  • Designed to manage foreign participation in domestic debt markets. 
• Fully Accessible Route
  • Introduced by the Reserve Bank of India in 2020. 
  • Permits non-resident investors to invest in specified government securities without investment caps. 
  • Aims to integrate Indian debt markets with global financial markets. 
  • The inclusion of Indian government bonds in major global bond indices in recent years has further increased foreign investor interest.

Benefits of Foreign Investment in Government Bonds

• Foreign investment in government securities offers several advantages:
  • Stable Source of Capital
    • Government bonds generally attract long-term institutional investors such as sovereign wealth funds, pension funds, and insurance companies, providing relatively stable capital inflows.
  • Support for Government Borrowing
    • Higher demand for government securities can lower borrowing costs and improve debt market liquidity.
  • Strengthening External Sector Stability
    • Large foreign inflows help finance the current account deficit and support the country’s Balance of Payments (BoP) position.
  • Support for the Rupee
    • Increased foreign currency inflows improve dollar availability in the domestic market and can help reduce depreciation pressures on the rupee.

News Summary

• The Central Government has promulgated an ordinance amending the Income Tax Act, 2025, to exempt Foreign Institutional Investors from:
  • Long-term capital gains tax on government bonds. 
  • Short-term capital gains tax on government bonds. 
  • Withholding tax on interest income earned from government securities. 
  • The changes will take retrospective effect from April 1, 2026.
• Previously, foreign investors were required to pay:
  • 12.5% tax on long-term capital gains. 
  • 30% tax on short-term capital gains. 
  • Around 20% withholding tax on interest income from government bonds. 
  • The exemption also extends to the Bank for International Settlements (BIS), an international organisation of central banks.

Objective Behind the Decision

• The measure has been introduced amid concerns regarding:
  • Slowing foreign capital inflows. 
  • Pressure on the Indian rupee. 
  • A widening Balance of Payments deficit. 
• Economists estimate that India’s BoP deficit could reach $50-60 billion in FY27. Such a deficit can exert downward pressure on the rupee and increase external sector vulnerabilities.
• The government expects that tax-free returns on government securities will make Indian bonds more attractive relative to competing markets.

Expected Impact on Capital Inflows

• According to estimates cited in the report, the removal of these taxes could result in substantial foreign investment inflows over the next few years.
• Axis Bank economists estimate that the measure could attract approximately $45-50 billion of foreign investment into government bonds over two years.
• At present, foreign investors hold around Rs. 3.75 lakh crore worth of government securities, representing only about 3.34% of the total eligible government bond market of Rs. 112.42 lakh crore.
• This indicates significant room for expansion in foreign participation.

RBI Measures to Complement the Reform

• Alongside the tax changes, the Reserve Bank of India has announced additional steps to encourage foreign investment. These include:
  • Expanding the Fully Accessible Route (FAR) to cover all new issuances of 15-year, 30-year, and 40-year government bonds. 
  • Removing restrictions related to short-term investment limits. 
  • Relaxing concentration limits and security-specific limits for foreign portfolio investors under the General Route. 
• These reforms are intended to deepen India’s bond market and improve its attractiveness to global investors.

Implications for the Rupee and Bond Market

• The announcement had an immediate positive impact on government bond markets, with bond yields declining following the ordinance.
• Economists believe that stronger foreign inflows could:
  • Help bridge India’s external financing gap. 
  • Improve Balance of Payments stability. 
  • Strengthen foreign exchange reserves. 
  • Provide support to the rupee. 
• With greater foreign participation, India’s sovereign debt market could become more integrated with global financial markets.

Source: TH | IE