G-Sec tax exemption 2026: zero tax lifts FII returns

What changed and why it matters

The Centre has moved to make Indian government securities (G-Secs) materially more attractive for foreign investors by scrapping taxes on key returns from these instruments. Under a new ordinance, foreign investors will not have to pay income tax on interest income or capital gains arising from the transfer or redemption of government bonds. The policy is positioned as a push to attract overseas capital at a time when global conditions remain uncertain and capital flows are sensitive to risk. Market participants see the step as a meaningful reduction in the friction costs that have historically reduced post-tax returns in Indian sovereign debt. The broader objective is to strengthen India’s external position and ease pressure on the rupee. The announcement also comes alongside Reserve Bank of India measures intended to boost dollar inflows, though the tax change itself is the headline reform.

The ordinance and its effective date

The Central government issued the Income-tax (Amendment) Ordinance, 2026 on June 5. The ordinance, promulgated by President Droupadi Murmu, amends Schedule IV of the Income Tax Act, 2025. The exemption applies retrospectively from April 1, 2026, which makes it effective from the start of the current tax year. This retrospective applicability matters for foreign investors who may have already built positions in eligible government securities during the year. The ordinance adds new entries to formalise the tax-free treatment on interest and on capital gains from sale, exchange, transfer, or redemption of G-Secs for eligible entities. The framework also references prescribed disclosure and reporting requirements for eligibility.

Who gets the benefit

The exemption covers Foreign Institutional Investors (FIIs), foreign portfolio investors (FPIs) that are notified as FIIs, overseas investors, and the Bank for International Settlements (BIS). Separate reporting noted that the relief specifically applies to two categories: FIIs under the relevant provisions and BIS, the Basel-headquartered institution established in 1930. The ordinance therefore targets the segment of global investors most likely to participate in sovereign debt markets at scale. It also extends the benefit to BIS, a holder that can influence perceptions of stability and global participation. By widening the pool beyond a narrow set of institutions, the government is attempting to broaden participation while keeping eligibility tied to defined regulatory categories.

Taxes removed: interest, capital gains, and withholding

The key change is a full exemption from income tax on interest income earned on government securities and on capital gains arising from their sale, exchange, transfer, or redemption. Multiple reports also indicated that the withholding tax on interest income earned by foreign investors on government securities has been eliminated. Previously, foreign institutional investors were required to pay a 12.5% long-term capital gains tax on gains from government securities. Official sources also cited that FIIs had to pay a 12.5% tax on capital gains and a 20% withholding tax on interest earned from G-Secs, based on the tax treaty, which reduced India’s competitiveness relative to global peers. By removing these layers, policymakers are seeking to simplify the tax treatment and improve post-tax returns. The government’s stated aim is to reduce investment costs and encourage greater participation in India’s debt market.

The macro backdrop: an external funding gap focus

Market experts estimate India could face a $10-50 billion balance-of-payments gap (reported as about ₹4.76 lakh crore), heightening the need for fresh foreign capital. In that context, policymakers are using tax policy to make sovereign debt inflows easier to attract and more durable. The move is also framed as supportive for the rupee, especially if it helps stem outflows and improves the overall flow picture. Another assessment cited that the combined set of reforms could potentially bring more than $10 billion (around ₹3.81 lakh crore) into India. SBI Research said such reforms could strengthen the rupee, deepen bond markets, and boost long-term foreign participation. While the exact quantum of inflows will depend on global risk appetite and relative yields, the government is clearly aiming to improve India’s positioning as an investable large emerging market.

What experts are saying about returns and index inclusion

Rajesh H. Gandhi, Partner at Deloitte India, said the change could increase returns for FPIs from investment in Indian G-Secs by 15-20%. He also noted that the move improves the delta between returns on Indian sovereign bonds versus other countries, making India “a bit more attractive”. Separately, tax expert Dinesh Kanabar described the impact as an effective step-up in yield when tax leakage is removed, illustrating how net returns can rise when taxes on interest and capital gains are eliminated. Gandhi added that the reform makes India’s inclusion in global bond indices more meaningful, since tax was seen as a key hindrance. In addition, he said FPIs investing only in government securities would be free from tax compliances such as return filing and related requirements. The broader inference from these comments is that the policy attempts to remove both economic and administrative barriers.

Why the move may not be sufficient on its own

Experts have also cautioned that tax relief alone may not bridge the entire external funding gap. One expert, Gupta, flagged that geopolitical risks and elevated crude prices can still weigh on capital flows. He also pointed to hedging costs as a practical constraint for foreign investors evaluating rupee-denominated assets. Secondary market liquidity constraints and currency convertibility issues were cited as additional factors influencing investor decisions. These concerns matter because foreign participation in local currency bonds is not driven purely by headline yield or tax treatment. Execution factors such as the ability to enter and exit positions efficiently can be decisive during periods of volatility. As a result, the reform is best read as a significant enabling step rather than a guaranteed inflow trigger.

What it means for the bond market and the rupee

By improving post-tax returns and removing withholding friction, the exemption is expected to raise the attractiveness of Indian sovereign debt for overseas investors. Greater foreign participation can deepen trading activity and potentially improve market liquidity over time, though the pace will depend on how investors respond. Policymakers are also attempting to support the rupee by encouraging more stable, longer-tenor inflows into government securities. Official sources have linked stable foreign investment in longer-tenor government securities to support for government spending and investment, including infrastructure, urbanisation, climate transition, manufacturing, and social sector development. The measure is also framed as a step to help contain the widening of the current account deficit by supporting the overall external financing mix. However, whether it reverses broader foreign outflows “remains to be seen,” as one report put it.

Key facts at a glance

Why this is being called a major reform

Multiple reports described the decision as one of the most significant bond-market reforms in recent years because it tackles a long-standing deterrent for foreign investors: post-tax return uncertainty and friction. In sovereign debt, small differences in net yield can influence allocation decisions, particularly when investors compare emerging markets on a risk-adjusted basis. By moving to zero tax on interest and capital gains for defined foreign entities, the government is signalling that it wants to be competitive with global peers. The removal of withholding tax on interest also simplifies execution, which can matter as much as headline rates. The policy is also linked by experts to improving the practicality of global bond index inclusion, where operational simplicity and tax clarity can influence investor participation. Still, the broader outcome will depend on how risks such as geopolitics and commodity prices evolve.

Conclusion

India’s tax exemption for foreign investors in G-Secs, effective retrospectively from April 1, 2026, removes income tax on interest and capital gains and eliminates withholding tax on interest for eligible entities including FIIs and BIS. The move is designed to improve post-tax returns, reduce compliance friction, and encourage incremental inflows into Indian sovereign debt. Policymakers and market participants are linking the reform to support for the rupee and to narrowing an estimated $10-50 billion external funding gap. At the same time, experts have highlighted that factors such as hedging costs, liquidity, and geopolitical risks will still shape investor decisions. The next key step will be how quickly foreign investors recalibrate allocations as the new tax treatment takes effect across the current tax year.