India Issues Ordinance to Exempt Foreign Investment in Government Securities from Capital Gains Tax

Background and Context

The Indian government's recent decision to exempt foreign investors from income tax on interest earnings and capital gains from government securities is part of a broader strategy to bolster the country's economic resilience. This move comes at a time when emerging markets, including India, are facing significant challenges due to global uncertainty and elevated energy prices. The rupee has weakened by over 6 percent this year, driven by rising crude oil prices and foreign portfolio outflows from equities. Historically, similar measures have been employed by other emerging markets to attract foreign capital and stabilize their economies during periods of financial stress.

Tax Exemptions for Foreign Capital

The Indian government has promulgated an ordinance to amend the Income Tax Act, effectively exempting foreign institutional investors (FIIs) and the Bank for International Settlements (BIS) from income tax on interest earnings and capital gains derived from government securities. This legislative change, formalized through a gazette notification on June 5, applies retroactively from April 1. By removing the tax burden on these specific financial instruments, the government aims to stimulate foreign capital inflows into the sovereign debt market.

Previously, foreign investors faced a 12.5 percent long-term capital gains tax on listed bonds held for over a year, alongside a 20 percent withholding tax on interest income. The new ordinance bypasses these fiscal hurdles for eligible entities, provided they adhere to mandatory information-reporting requirements. President Droupadi Murmu signed the ordinance under Article 123 of the Constitution, a measure deemed necessary due to Parliament currently being out of session.

The exemption is expected to make India's government bond market more attractive to foreign investors, thereby facilitating government borrowing at more affordable interest rates. This is crucial for maintaining fiscal stability and supporting economic growth, especially in the face of global economic headwinds.

Why it matters

This policy shift serves as a strategic response to the weakening rupee, which has depreciated by more than 6 percent this year. Global economic pressures, including elevated crude oil prices and significant foreign portfolio outflows from domestic equities, have created a challenging environment for India's balance of payments. By incentivizing investment in government securities, the administration intends to strengthen external financing buffers and stabilize the currency against ongoing global volatility.

The move mirrors historical patterns where emerging markets adjust fiscal policies to ensure sovereign borrowing remains affordable during periods of financial stress. By lowering the cost of entry for international capital, the government seeks to maintain a steady flow of funds that can support domestic economic stability. This decision is part of a broader effort to ensure that the country remains an attractive destination for foreign capital despite the current climate of uncertainty in emerging markets.

Public impact is significant, as a more stable rupee and increased foreign investment can lead to improved economic conditions for Indian citizens. This includes potential job creation, increased economic activity, and better access to capital for domestic businesses. Additionally, the measures can help mitigate the impact of rising energy prices on the cost of living for ordinary Indians.

RBI Measures and Market Impact

Complementing the tax ordinance, the Reserve Bank of India (RBI) has introduced a series of operational adjustments to broaden market access. The central bank has expanded the Fully Accessible Route (FAR) to include new 15-year, 30-year, and 40-year sovereign bonds. Furthermore, the RBI has eliminated concentration limits and restrictions on short-term investments for Foreign Portfolio Investors (FPIs) operating through the General Route.

These changes extend beyond institutional players, as the RBI has also increased investment limits for non-resident Indians and Overseas Citizens of India in listed equity instruments. By removing the requirement for registration with the securities regulator for these groups, the central bank has effectively broadened the pool of potential investors. Additionally, the RBI is offering a concessional foreign-exchange swap facility for external commercial borrowings by public sector undertakings, alongside a temporary hedging cost facility for FCNR(B) deposits.

The RBI's measures are designed to attract stable foreign capital flows, ease external financing conditions, and strengthen India's balance of payments. This is particularly important given the heightened global volatility and the need for robust economic buffers. The central bank's actions, coupled with the government's tax exemptions, are expected to enhance foreign participation in India's sovereign debt market and support the rupee.

What happens next

The immediate focus for market participants will be the implementation of the new reporting requirements necessitated by the ordinance. Because the measure was enacted via an ordinance, it will eventually require formal parliamentary approval to remain permanent law once the next session commences. Financial institutions and foreign investors will be monitoring the regulatory guidelines that define the specific procedures for claiming these tax exemptions.

Looking at the timeline for the RBI’s support measures, the concessional foreign-exchange swap facility and the hedging cost support for FCNR(B) deposits are scheduled to remain available until September 30, 2026. These deadlines provide a window for public sector undertakings and banks to adjust their strategies and take advantage of the favorable conditions. In the longer term, the success of these measures will be evaluated based on their ability to attract and retain foreign investment, stabilize the rupee, and support overall economic growth.

If successful, these initiatives could set a precedent for future policy responses to economic challenges, both in India and other emerging markets. The global financial community will be watching closely to see if these measures achieve their intended goals and whether similar strategies might be adopted elsewhere.

As reported by ThePrint.