Why in news?

India is considering reducing the withholding tax on foreign investors’ earnings from Indian bonds from 20% to 5% to attract overseas capital inflows.

The move comes as India’s foreign exchange reserves have declined sharply amid the West Asia conflict and rising crude oil prices, increasing external economic pressure.

Lowering this tax is aimed at making Indian bonds more attractive to foreign investors and strengthening capital inflows as part of broader efforts to manage the external sector and conserve foreign exchange.

Reducing the withholding tax could increase foreign investors’ net returns, make Indian debt instruments more attractive, encourage greater capital inflows, and help support India’s foreign exchange reserves during global uncertainty.

What’s in Today’s Article?

• About Withholding Tax
• Evolution of India’s Withholding Tax Regime
• Withholding Tax Practices Across Countries
• FPI Investment in India’s Government Debt
• Why There Are Demands to Cut Withholding Tax?

About Withholding Tax

• Withholding tax (WHT) is a tax collected at the source of income.
• Instead of waiting for the taxpayer to pay at the end of the financial year, the payer deducts a portion of the income before transferring it to the recipient and deposits that amount directly with the government.
• It applies to income earned through employment, investments, royalties, and other sources, ensuring advance tax collection.

Evolution of India’s Withholding Tax Regime

• Expiry of the Concessional Rate - India had introduced a concessional 5% withholding tax on interest earned by foreign investors from investments in government securities and certain rupee-denominated bonds under Section 194LD of the Income Tax Act.
• Tax Rate Hike After July 2023 - The concessional regime expired in July 2023, after which the effective withholding tax for many foreign investors reverted to around 20%, making Indian debt relatively less attractive for global bond investors.
• Impact on Foreign Capital Inflows - The higher tax burden reduced the appeal of Indian debt instruments at a time when India was seeking stronger foreign capital inflows and inclusion in global bond indices.
• Historical Evolution in Other Areas
  • India’s withholding tax regime has changed significantly over time. In 1976, withholding tax on royalties paid to non-residents was 40%, while fees for technical services attracted 20%.
  • Between 1986 and 2005, the government reduced withholding tax on royalties and technical services to 10% to lower technology acquisition costs and encourage foreign collaboration.

Impact of Withholding Tax Cut on Foreign Portfolio Investors (FPIs)

• Higher Post-Tax Returns - Withholding tax reduces FPIs’ effective yields because tax is deducted before investment income is paid. Lowering the tax would improve post-tax returns and overall investment gains.
• Better Compounding and Reinvestment - A high withholding tax reduces the amount available for immediate reinvestment, weakening the benefits of long-term compounding. A lower tax rate would free up more capital for reinvestment.
• Improved Liquidity for Global Investors - For large international investors, withholding tax can temporarily lock up funds until tax credits or refunds are processed, creating short-term liquidity pressures. Lower taxes would ease this constraint.
• Reduced Compliance Burden - FPIs often face administrative difficulties in claiming tax relief under Double Taxation Avoidance Agreements (DTAAs). A lower withholding tax would reduce compliance costs and regulatory friction.
• Greater Market Attractiveness - By lowering transaction costs and improving risk-adjusted returns, a reduced withholding tax would make Indian financial markets more attractive to overseas investors.

Withholding Tax Practices Across Countries

• Most countries impose withholding tax on foreign investors, particularly on passive income such as interest, dividends, and royalties.
• The tax rate, coverage, and exemptions vary depending on the country, investor category, and the presence of DTAA.
  • United States: 30%
  • Germany: 26.4%
  • France: 25%
  • China: 10%
  • Hong Kong: No withholding tax
  • Singapore: No withholding tax

FPI Investment in India’s Government Debt

• FPI hold a relatively small share of India’s government debt market, though their participation has increased significantly following India’s inclusion in global bond indices such as the JPMorgan Government Bond Index-Emerging Market.
• The RBI has capped FPI investment in government securities at 6% of the outstanding stock.
• By March 2025, FPI investment in dated government securities had risen sharply by 43.2%, increasing from $30.6 billion to $43.9 billion year-on-year.

Why There Are Demands to Cut Withholding Tax?

• High Tax Reduces India’s Attractiveness - Analysts argue that India’s 20% withholding tax on interest income makes Indian debt less attractive compared to many peer countries, reducing foreign investor interest.
• Barrier to Global Bond Index Inclusion - High taxation and procedural hurdles delayed India’s inclusion in major global bond indices. Lower taxes and simpler processes could significantly boost foreign capital inflows.
• Potential for Large Capital Inflows - Experts estimate that greater tax clarity or exemptions could bring $45–50 billion in inflows over two years, while also attracting pension funds and endowment investors.
• Global Competition - Several countries do not tax bond investments, while countries like China offered special tax exemptions after bond index inclusion to attract foreign investors, making India comparatively less competitive.
• Recent FPI Debt Outflows - After the concessional withholding tax regime ended in 2023, foreign investors faced higher tax costs. As a result, India’s debt market has recently seen FPI outflows, indicating weaker investor sentiment.