India’s Tax Exemption for Foreign Investors in Government Securities

India has introduced a significant tax exemption for certain foreign investors on their income and capital gains from government securities. This move, enacted through an ordinance on June 5, 2026, aims to attract foreign capital, stabilize the Indian rupee, and deepen the country’s sovereign debt markets. The exemption specifically targets Foreign Institutional Investors (FIIs) and the Bank for International Settlements (BIS), offering them a more attractive post-tax return on their investments in Indian government debt.

This policy change is designed to encourage greater foreign participation in India’s debt market, especially during a period of global economic uncertainty and pressure on the rupee. By reducing the tax burden, India hopes to offset potential outflows and increase the appeal of its sovereign bonds to international investors.

Understanding the Tax Exemption

The exemption, detailed in the Income-tax (Amendment) Ordinance, 2026, applies to two main types of income derived from government securities: interest earned and capital gains realized from the sale, exchange, or transfer of these securities. To benefit from this relief, eligible investors must provide specific information in the prescribed format. This ensures that the exemption is applied precisely to the intended beneficiaries and financial instruments.

The ordinance amends the Income-tax Act, 2025, and is considered effective from April 1, 2026. It introduces new sections, 13D and 13E, into Schedule IV of the Act. These sections clearly define the scope of the exemption, linking it to existing legal definitions of “Foreign Institutional Investor” and “Government security.” This precise framing means the exemption does not extend to other asset classes like equity shares, mutual funds, or private bonds.

Previous Tax Landscape for FIIs

Before this ordinance, FIIs investing in Indian securities were generally subject to a special tax regime under Section 115AD of the Income-tax Act, 1961. This framework imposed taxes on income from securities and capital gains from their transfer. Long-term capital gains on listed shares and bonds were taxed at a rate of 12.5%, while short-term capital gains faced higher rates, typically 30% or 15%/20% depending on the timing and type of security.

Furthermore, FIIs often could not claim standard benefits like indexation or foreign currency adjustments when calculating capital gains under Section 115AD. This limitation made the statutory tax rate a critical factor for investors considering Indian sovereign debt. The new exemption directly addresses this by removing the tax on covered interest and capital gains, thereby improving the net returns for eligible investors.

Rationale Behind the Policy Shift

The timing of this tax exemption is closely linked to recent economic trends. Market reports indicate substantial foreign portfolio investor outflows from India in 2025 and 2026, exceeding previous years. Concurrently, the Indian rupee has experienced significant depreciation, reaching an all-time low against the U.S. dollar in May 2026.

By attracting foreign investment into government securities, India aims to increase the inflow of foreign currency, which can help support the rupee. A wider base of foreign investors in the sovereign debt market also strengthens demand for government borrowing. This policy is part of a broader strategy to enhance India’s financial stability and economic resilience amidst global economic headwinds.

Broader Market and Regulatory Context

This tax relief is not an isolated measure. It complements other initiatives by the Reserve Bank of India (RBI) to ease foreign access to the bond market. The RBI has been working to remove operational restrictions for foreign portfolio investments in government securities, such as short-term investment limits and concentration limits. These regulatory adjustments, combined with the tax exemption, aim to create a more favorable and accessible environment for foreign institutional investors.

The inclusion of Indian government securities in major global bond indices has also increased their visibility and appeal. As global funds often track these indices, a lower tax friction makes Indian sovereign debt a more attractive component of international fixed-income portfolios. This can lead to increased liquidity and a deeper, more robust sovereign debt market for India.

Limitations and Scope of the Exemption

It is important to note that the tax exemption is narrowly defined. It applies exclusively to FIIs and the Bank for International Settlements, and only to income derived from government securities. It does not extend to ordinary non-resident Indians (NRIs) who invest in other Indian assets like shares, mutual funds, or real estate. These investors continue to be subject to existing tax regulations.

The ordinance does not represent a blanket tax holiday for all foreign investors or a complete removal of capital gains tax for all types of Indian investments. The relief is specific to the defined eligible entities and the specified income stream from government securities. This targeted approach ensures that the policy achieves its intended objectives without creating unintended consequences for other market segments.

The government appears to be betting that the increased foreign participation, improved market liquidity, and a more developed sovereign debt market will ultimately outweigh the immediate loss of tax revenue. This strategic move is expected to contribute to broader market stability and ease pressure on government borrowing costs over the long term. While currency markets will continue to be influenced by various global and domestic factors, this measure provides a clearer post-tax return profile for overseas bond investors, offering support to the rupee.