A Tax Fix That Can Attract More Foreign Capital

UPSC Syllabus: Gs Paper 3- Indian Economy

Introduction

India is facing sustained foreign capital outflows from its equity markets, while its corporate debt market also needs deeper domestic and foreign participation. With the interest-rate gap between India and the US near historic lows, raising domestic rates to support the rupee could increase borrowing costs and weaken corporate earnings. Tax reforms offer an alternative by improving post-tax returns and strengthening market liquidity.

Why Is Foreign Capital Leaving Indian Markets?

1. Declining foreign investment: Foreign investors’ holdings in Indian stocks have reached an all-time low of 14%, reflecting weaker interest in Indian equities.
2. Large capital outflows: Foreign investors withdrew a net $18.9 billion in 2025 and more than $30 billion so far in 2026, indicating sustained withdrawals.
3. Poor market performance: India ranked the third worst-performing market after Indonesia and Turkey between January and October 2026. The Nifty 50 had declined nearly 9%.
4. Expensive market valuations: India’s rolling 12-month forward price-to-earnings (P/E) ratio stood at 18.6, above Taiwan’s 16.8 and Korea’s 3.9, making alternative markets relatively cheaper.
5. Disappointing earnings growth: India’s forecast earnings growth is 11%, against the emerging-market average of 45%, weakening the justification for its higher market valuations.
6. Rising investment risks: Strained US ties, higher energy prices, rupee depreciation, geopolitical tensions and uncertainty over artificial intelligence have increased perceived investment risks.
7. Changing relative returns: Foreign investors invested ₹570 billion in September 2024, but withdrew ₹940 billion in October to pursue cheaper Chinese stocks, despite unchanged Indian tax rates.

Tax-Related Barriers to Foreign Investment in India

1. Higher LTCG tax burden: The long-term capital gains (LTCG) tax was increased in 2024, prompting the market regulator and PHD Chamber of Commerce and Industry to demand its removal for foreign portfolio investors (FPIs).
2. Uncertain treaty benefits: The Principal Purpose Test under the India-Mauritius Double Taxation Avoidance Agreement (DTAA) allows authorities to deny treaty benefits when obtaining those benefits is one of the principal purposes of an arrangement.
3. Limited India-US tax exemption: Article 13 of the India-US DTAA allows both countries to tax capital gains under domestic law, while Article 25 provides relief from double taxation, subject to US tax rules.
4. Rupee-based capital gains calculation: India calculates capital gains in rupees, so depreciation can create taxable gains even when foreign investors sell their investments at unchanged dollar values.
5. Lower post-tax returns: High taxes reduce the attractiveness of Indian debt investments when global funds compare post-tax returns across different investment markets.

Need for Tax Parity Between Debt and Equity Investments

1. Unequal tax treatment of debt and equity funds: Equity funds face 12.5% tax on long-term gains and 20% on short-term gains, while specified debt-fund gains are taxed at marginal rates, reaching 30% for the highest tax bracket before cess and surcharge.
2. Need for greater domestic participation: Favourable debt-fund taxation can increase domestic investment and assets under management (AUM), expanding the investor base and improving corporate bond market depth.
3. Importance of pooled investment vehicles: Debt mutual funds and corporate bond Exchange-Traded Funds (ETFs) provide diversified exposure, avoiding the difficulty of purchasing and holding individual corporate bonds.

Proposed Tax Reforms to Attract Foreign Capital

1. Review foreign equity LTCG: The market regulator and PHD Chamber have urged the removal of LTCG tax for foreign investors, while the Finance Minister has agreed to consider the demand.
2. Rationalise debt-fund taxation: Bringing debt-fund tax treatment closer to equity funds could reduce the existing disadvantage and encourage greater domestic investment.
3. Reduce tax on foreign debt investments: Lower taxation on debt gains can improve post-tax returns and reduce the disadvantage arising from rupee depreciation when foreign investors calculate returns in their home currencies.
4. Extend government-security tax incentives: Eligible foreign investors already receive income-tax exemptions on interest and capital gains from government securities. Extending similar incentives to corporate debt could attract foreign investment and deepen the market.

How Can Tax Reforms Strengthen India’s Financial Markets?

1. Support foreign exchange inflows: Greater foreign investment can increase foreign exchange inflows and support rupee stability, reducing excessive dependence on scarce foreign exchange reserves.
2. Improve corporate bond liquidity: Greater domestic participation can expand the investor base, strengthen trading activity and improve liquidity in the corporate bond market.
3. Facilitate large-volume transactions: A deeper market allows foreign investors to trade substantial volumes without causing sharp price movements or incurring substantial losses.
4. Reduce pressure for interest-rate hikes: Tax reforms offer an alternative to raising domestic interest rates, which increase borrowing costs, squeeze corporate profit margins and weaken earnings growth.

Limitations of Tax Cuts and the Need for Broader Reforms

1. Revenue loss for the government: Tax reductions would lower government revenue, making the Finance Minister cautious about removing or reducing capital gains taxes.
2. Importance of strong economic fundamentals: Tax cuts alone cannot reverse capital outflows. Investors also need predictable earnings growth and reasonable valuations to justify India’s premium over competing markets.
3. Persistent geopolitical and technological risks: Geopolitical tensions and uncertainty surrounding artificial intelligence can continue to weaken long-term growth expectations, even after improvements in tax rules.
4. Limited impact of temporary market support: Lower global bond yields and expectations of rupee support through central bank intervention may improve market sentiment, but cannot resolve structural investment concerns.

Conclusion

India needs a competitive tax regime for both equity and debt investments. Reviewing LTCG taxation and reducing the disadvantage faced by debt funds could improve post-tax returns, deepen corporate bond markets and support foreign exchange inflows. However, sustained investment will also depend on stronger earnings, reasonable valuations and lower economic uncertainty.

Question for practice:

Discuss how tax reforms can help attract foreign capital, strengthen India’s financial markets and address the challenges of declining foreign investment.

Source: Businessline