Capital gains tax exemption for FPIs in government bonds seen boosting foreign inflows, bond market appeal

The government's decision to exempt foreign institutional investors (FIIs), including foreign portfolio investors (FPIs), from tax on interest income and capital gains earned from investments in government securities is expected to enhance the attractiveness of Indian sovereign bonds and support long-term foreign capital inflows. 

Tax relief takes effect retrospectively from April 1, 2026

The exemption, introduced through an Ordinance and effective from April 1, 2026, removes taxes on interest income as well as gains arising from the transfer or redemption of government securities. 

Under the earlier tax regime, FPIs were subject to a specific taxation framework under Section 210 of the Income-tax Act, 2025. Interest income from securities was taxed at 20%, while long-term capital gains on government securities were generally taxed at 12.5% and short-term capital gains at 30%, depending on the nature of the transaction. 

The decision comes at a time when foreign investors have pulled out nearly ₹2.6 lakh crore from Indian equities so far in 2026, significantly higher than the ₹1.66 lakh crore withdrawn during the whole of 2025, amid escalating geopolitical tensions. In the first three trading sessions of June alone, foreign investors offloaded equities worth around ₹34,000 crore, adding further pressure on the rupee.  

The move marks a key shift in the tax treatment of foreign investments in government bonds. Interest income on certain government securities had enjoyed exemptions until 2002, while a concessional 5% tax regime was available for specified periods between 2013 and 2023. Thereafter, normal tax provisions became applicable. 

Government securities, which may be listed or unlisted, typically do not attract Securities Transaction Tax (STT). As a result, foreign investors were generally unable to avail themselves of concessional capital gains tax provisions linked to STT compliance. 

The exemption applies to investments made through both the General Route and the Fully Accessible Route (FAR), under which foreign investors participate in the government securities market. 

As of May 12, 2026, FPIs held government securities worth ₹3.75 lakh crore, accounting for 3.34% of the outstanding stock of ₹112.42 lakh crore. Investments through the General Route stood at ₹54,091 crore, or 0.83% of the eligible stock, while holdings under the FAR route amounted to ₹3.21 lakh crore, representing 6.74% of the eligible stock. 

Adhil Shetty, CEO of BankBazaar, said the tax exemption removes a key impediment for overseas investors evaluating Indian debt markets. "The decision to exempt foreign investors from tax on interest income and capital gains from government securities is a significant step towards making Indian government bonds more attractive to global investors. Tax treatment is a key factor when international investors compare opportunities across markets," Shetty said. 

He noted that foreign participation in India's government bond market remains relatively low despite recent reforms and inclusion in global bond indices. "Along with the easing of investment restrictions announced today, the tax exemption improves the overall attractiveness of the asset class for long-term investors such as pension funds, insurance companies and sovereign wealth funds," he added. 

According to Shetty, the measure could help broaden the investor base for government borrowing and support more stable foreign capital inflows over time. 

BIS also gets tax relief 

The Ordinance has also extended similar tax exemptions to the Bank for International Settlements (BIS), a global institution owned by central banks that facilitates international monetary and financial cooperation. 

Under the revised framework, BIS will be exempt from tax on interest income and capital gains arising from investments in government securities through specified rupee-denominated investment pools managed under the BIS Investment Pool (BISIP) programme. 

The exemption, however, is restricted to income earned from government securities and does not apply to other BIS operations in India. Government data shows BIS has not yet invested in Indian government securities. 

Support for global bond index inclusion 

Nehal Sampat, Partner at Price Waterhouse & Co LLP, said the Ordinance removes an important tax friction for foreign investors. "The exemption of interest income and capital gains earned by FPIs from investments in government securities, effective April 1, 2026, could improve the attractiveness of Indian debt markets. Funds and offshore banking units in IFSC registered as FPIs may also be eligible for the benefit," Sampat said. 

He added that the move could strengthen India's integration with global bond markets and encourage higher foreign participation in government securities over time.