Withholding Tax

News: India’s foreign exchange reserves have fallen by nearly $38 billion since March due to capital outflows linked to the West Asia conflict. To attract overseas investments, the government is reportedly considering reducing the withholding tax rate from 20% to 5%.

About Withholding Tax

• Withholding tax is paid by foreign investors on the interest they earn on their holding of Indian bonds.
• It is tax collected at the source of income. 
• Instead of waiting for an investor or foreign company to pay taxes at the end of the financial year, the government requires the payer to deduct a portion of the income before it is remitted to the recipient.
  • The deducted amount is then directly deposited with the government
• It applies to income earned through employment, investments, royalties, and other sources, ensuring advance tax collection.
• Impacts of Withholding Tax on Foreign Portfolio Investors (FPIs):
  • It reduces foreign portfolio investors’ (FPIs) effective yields and overall investment returns because it is deducted at the source before interest, dividends or other investment income is remitted to them. 
    • This compresses investors’ post-tax returns, weakens the power of long-term compounding and limits the amount of capital available for immediate reinvestment.
  • For large global investors operating across multiple jurisdictions, such deductions can also create short-term liquidity constraints by locking up funds until tax credits or refunds are processed.
  • FPIs often face significant administrative and compliance burdens in claiming relief under Double Taxation Avoidance Agreements (DTAAs). 
  • Higher withholding taxes may reduce the attractiveness of a market by increasing transaction costs, lowering risk-adjusted returns and creating regulatory friction for overseas investors.
• Withholding tax impact on India: A high withholding tax is seen as a major deterrent for foreign capital inflows at a time when India is grappling with rising external pressures, including a sharp surge in crude oil prices.
  • Reducing Withholding tax is needed as the government has already proposed several measures to curb outflows and manage the external account, including cuts in expenditure and restrictions on foreign travel, gold imports and other non-essential spending. 
  • Lowering the withholding tax could improve post-tax returns for foreign investors, make Indian debt and other financial assets more attractive, and help stabilize forex reserves amid heightened global uncertainty.