Bond tax break targets overseas capital

New Delhi scrapped capital gains tax on foreign institutional investment in government securities, using an ordinance to sharpen the appeal of its sovereign debt market and draw overseas capital as the rupee faces pressure from higher energy costs and equity outflows.

The exemption, effective from 1 April 2026, covers interest income and capital gains arising from the sale, exchange or transfer of specified government securities by eligible foreign institutional investors and the Bank for International Settlements. President Droupadi Murmu signed the Income-tax Ordinance, 2026 while Parliament was not in session, amending the new direct tax framework that took effect at the start of the financial year.

Foreign investors had been subject to long-term capital gains tax of 12.5% on listed bonds held for more than 12 months and withholding tax of 20% on interest from government securities. By removing the tax burden for eligible investors, the Centre is seeking to improve post-tax returns and make rupee debt more competitive at a time when global funds are weighing currency risk, oil-market volatility and geopolitical uncertainty.

The policy shift comes as the rupee has weakened by more than 5% this year, pressured by crude prices and sustained foreign selling in equities. The currency recovered after the announcement of measures aimed at attracting foreign currency inflows, but traders continued to watch oil prices, reserve levels and the central bank’s market operations for signs of durable support.

Reserve Bank of India kept the policy repo rate unchanged at 5.25% and announced steps to encourage dollar inflows, including support for foreign-currency borrowing by public sector entities, incentives for non-resident deposits and a longer window for exporters to repatriate proceeds. The central bank also revised its growth forecast to 6.6% and raised its inflation estimate to 5.1%, underlining the pressure created by imported energy costs.

The tax relief is aimed at deepening overseas participation in government securities after the inclusion of rupee bonds in major global debt benchmarks. Fully accessible route bonds have already been added to J. P. Morgan’s emerging market debt index and Bloomberg’s emerging market local currency index, widening the pool of passive and active investors that can allocate funds to sovereign debt. A separate decision on inclusion in broader global bond benchmarks is being watched by investors because it could influence medium-term flows.

Debt inflows have remained more resilient than equity flows, but the scale has not been sufficient to offset pressure from the current account and stock-market exits. Foreign investors have pulled large sums from equities this year, while government debt has continued to attract selective buying. Higher hedging costs and expectations of currency weakness have limited enthusiasm among some global investors despite the comparatively attractive yield on rupee bonds.

Market participants expect the tax exemption to help long-only funds, pension funds, sovereign investors and reserve managers that focus on net returns after tax. The measure could also support liquidity in benchmark government securities and reduce borrowing costs at the margin if foreign demand rises. For the Centre, a broader investor base would help absorb a large borrowing programme without placing excessive pressure on domestic banks and insurance companies.

The effect may still depend on factors beyond tax policy. Currency stability, inflation expectations, oil prices, fiscal credibility and the central bank’s approach to liquidity will shape overseas appetite. Investors that hedge currency exposure must still account for hedging costs, while those that remain unhedged face the risk of rupee depreciation wiping out yield gains.