Tax Cut May Not Revive Foreign Bond Inflows into India without Underlying Economic Reforms

India Weighs Tax Cuts to Attract Foreign Investors Amid Capital Outflows

India's foreign exchange reserves have taken a hit of nearly $38 billion since tensions in West Asia escalated, prompting the government to consider reducing the withholding tax rate on bonds from 20% to 5% to attract foreign portfolio investors (FPIs). However, experts believe that a tax reduction alone may not be enough to bring meaningful inflows back into Indian debt markets.

Market participants argue that while lower taxes may improve India's long-term appeal, foreign investors remain concerned about the weakening rupee, rising global bond yields, and elevated oil prices. Deepak Shenoy, founder of Capitalmind PMS, points out that India's taxation framework for foreign investors is out of step with global markets.

According to Shenoy, India is the only major economy that taxes capital gains made by foreign investors on all their investments in the country. In contrast, most countries follow residence-based taxation, where capital gains are taxed in the country of residence, not the country of investment. This results in FPIs paying tax on capital gains when bond prices rise due to falling interest rates, making it especially complicated for passive funds tracking global bond indices.

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Shenoy also highlights the complexity around accrued interest taxation in the secondary bond market, where foreign investors buying bonds between coupon payment dates pay accrued interest upfront, but the tax deductions can be substantial. He recommends that 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.

However, experts caution that such measures are unlikely to immediately reverse foreign outflows. Dr Joseph Thomas, Head of Research at Emkay Wealth Management, notes that reducing withholding tax "by itself is not going to bring in any funds into India." He attributes the biggest deterrent to currency depreciation, with the Indian Rupee recently crossing the 96-per-dollar mark.

Thomas suggests that overseas investors first need confidence that the rupee has stabilised before they can meaningfully assess bond returns. He also points to rising bond yields as another challenge, driven by inflation concerns and rupee weakness.

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Vishal Goenka, co-founder of IndiaBonds.com, agrees that the proposed tax rollback is a positive structural move but notes that global macro conditions continue to dominate investor decisions. He suggests that India needs broader structural reforms to deepen its bond markets and improve liquidity, including rationalising taxation on bond interest income for domestic investors.

V K Vijayakumar, Chief Investment Strategist at Geojit Investments, believes that the proposed tax changes may improve sentiment marginally but are unlikely to materially alter the broader FPI stance towards India. He notes 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.