Rationalising Withholding Tax for Strengthening India’s Debt Market

Context

India is considering reducing the withholding tax on interest earned by foreign investors from Indian bonds from 20% to 5%. The proposal comes amid pressure on foreign exchange reserves due to rising crude oil prices and the ongoing West Asia conflict. The measure is intended to encourage overseas investment in Indian debt instruments and support external sector stability.

Withholding Tax

Withholding Tax (WHT) is a tax deducted at the source before income is transferred to the recipient. The deducted amount is deposited directly with the government on behalf of the taxpayer. It applies to income such as salaries, interest, dividends, royalties, and technical service fees, ensuring advance tax collection.

Evolution of India’s Withholding Tax Regime

1. India earlier provided a concessional 5% withholding tax under Section 194LD of the Income Tax Act on interest earned by foreign investors from government securities and specified rupee-denominated bonds.
2. The concessional regime ended in July 2023, after which the effective tax rate for many foreign investors increased to nearly 20%.
3. The increase reduced the relative appeal of Indian debt instruments for global investors.
4. India has also rationalised withholding taxes in other sectors over time. Tax rates on royalties and technical service fees paid to non-residents were gradually reduced to promote technology transfer and foreign collaboration.

Implications of Reducing Withholding Tax

1. Higher Effective Returns: Lower tax deductions would increase net earnings for Foreign Portfolio Investors (FPIs).
2. Greater Reinvestment Potential: More retained income would improve reinvestment capacity and long-term compounding benefits.
3. Improved Liquidity Conditions: Reduced dependence on tax refunds and credits would ease short-term liquidity pressures faced by investors.
4. Simpler Tax Compliance: Lower tax rates would reduce procedural difficulties associated with Double Taxation Avoidance Agreements (DTAAs).
5. Increased Investor Participation: Competitive taxation would encourage broader foreign participation in India’s debt market.

International Practices

Countries adopt different withholding tax structures for foreign investors:

1. United States – 30%
2. Germany – 26.4%
3. France – 25%
4. China – 10%
5. Hong Kong – No withholding tax
6. Singapore – No withholding tax

Several economies use tax concessions to attract global capital into domestic bond markets.

FPI Participation in India’s Government Securities

1. FPIs account for a limited share of India’s government debt market.
2. The RBI has capped FPI investment in government securities at 6% of the outstanding stock.
3. Participation has increased after India’s inclusion in global bond indices such as the JPMorgan Government Bond Index–Emerging Markets.
4. By March 2025, FPI investment in dated government securities increased from $30.6 billion to $43.9 billion year-on-year.

Demand for Tax Rationalisation

1. India’s current tax structure is considered relatively high compared to competing financial markets.
2. Simplified taxation could support sustained inflows linked to global bond index inclusion.
3. A stable and predictable framework may attract long-term institutional investors such as pension and sovereign wealth funds.
4. Several countries offer lower taxes or exemptions to remain competitive in attracting foreign investment.
5. Higher tax costs after 2023 contributed to recent FPI outflows from India’s debt market.

Conclusion

Reducing withholding tax can deepen India’s debt market, improve investor confidence, and support external sector resilience. A balanced and globally competitive tax framework will be important for strengthening India’s integration with international financial markets.