FPIs seek review of capital gains tax amid sustained outflows

Growing Pressure from Foreign Investors on Tax Policy

Foreign portfolio investors operating in India are intensifying their push for a comprehensive review of the country's capital gains tax framework. Representatives from major FPI funds have escalated their concerns directly to market regulators and government officials, underlining the urgent need for policy certainty. The push comes amid significant capital outflows, with investors expressing growing frustration over multiple layers of taxation that are making India an increasingly unattractive destination compared to other emerging and developed markets globally. These discussions have reached the highest levels of financial regulation in India, signaling the seriousness with which the investment community views the current tax environment.

The Multiple Taxation Problem

One of the most pressing concerns raised by foreign investors involves the issue of double taxation on capital gains. According to FPI representatives, investors face a complex and costly taxation structure that effectively penalizes investment in Indian securities. Foreign investors are subject to capital gains tax when they invest in Indian securities, and then investors in these funds face taxation again in their home jurisdictions when they receive distributions from the FPI. This creates a situation where the same income is effectively taxed twice—once in India and again in the investor's home country. Additionally, the foreign tax credit mechanism, which theoretically allows investors to offset taxes paid in India against their home country obligations, is often unavailable or extremely difficult to claim in practice due to the complexity of fund structures and varying international tax regimes.

High Trading Costs Compound the Problem

Beyond taxation concerns, FPI representatives have highlighted the substantial trading costs that significantly erode returns on Indian investments. The costs include multiple levies that accumulate across the investment lifecycle: brokerage charges, stamp duty, securities transaction tax, Sebi turnover fees, exchange transaction fees, and custody charges. These costs collectively make trading in Indian markets considerably more expensive than in competing markets. When combined with capital gains taxation, these fees substantially reduce the net returns that foreign investors can achieve on their Indian equity holdings. The situation becomes particularly acute when compared to developed markets, particularly the United States, where foreign investors often face little to no capital gains tax on equity investments.

You already start with a 15 percent tax disadvantage and then add a weakening rupee. Explaining this return math to foreign investors becomes impossible.

Currency Depreciation Adds to Investor Woes

The challenges facing foreign investors extend beyond taxation policy to include currency-related headwinds. Capital gains tax is levied on rupee-denominated returns, but when investors convert rupees back to their home currencies, rupee depreciation erodes the dollar value of their gains. This creates a scenario where investors pay taxes on rupee returns that have already been reduced by currency depreciation, effectively amplifying the tax burden in terms of their home currency. The combination of capital gains taxation on weakening currency returns makes it increasingly difficult for India-focused investment funds to justify maintaining significant allocations to Indian equities when explaining returns to their global clients and stakeholders.

Competitive Disadvantage in Global Markets

Industry experts warn that India faces a significant competitive disadvantage in attracting foreign capital compared to other markets offering more favorable tax treatment. Many countries that successfully attract substantial foreign portfolio investment do not impose capital gains tax on listed equities for foreign investors. This structural advantage makes those markets inherently more attractive for global capital allocation decisions. When foreign investors evaluate opportunities across different emerging markets and developed economies, post-tax returns in their home currency become the primary consideration. India's combination of capital gains tax, securities transaction tax, multiple trading levies, and rupee depreciation risk creates a formidable headwind against competing destinations.

Historical Context of Tax Changes

The current concerns must be understood within the context of recent tax policy changes in India. Long-term capital gains tax on listed equity securities was entirely abolished in 2004 when the securities transaction tax was introduced. This created a tax-advantaged regime for equity investments compared to other asset classes. However, the government reintroduced long-term capital gains tax in 2018 at ten percent, with a one lakh rupee exemption threshold. These rates were subsequently increased in 2024, with the long-term capital gains tax rising to 12.5 percent and the exemption limit increasing to 1.25 lakh rupees. Short-term capital gains tax was also raised to twenty percent from fifteen percent. The 2024 changes proved particularly problematic because they occurred when global interest rates remained elevated and emerging markets were competing aggressively for scarce international capital.

Broader Implications for Capital Formation

Beyond immediate market concerns, experts warn that higher taxation on equities could disrupt India's long-term capital formation cycle. Healthy public markets serve a critical function in allowing private equity investors and venture capitalists to exit their positions, enabling the recycling of capital into new ventures and job creation initiatives. When public markets become less attractive to foreign investors due to adverse tax treatment, capital formation mechanisms weaken. Over time, this could force a shift toward foreign strategic ownership models rather than broadly-held domestic companies, ultimately constraining economic growth and entrepreneurship.

The debate over FPI taxation reflects a fundamental tension in Indian economic policy. While the government seeks to increase tax revenues from capital markets, the resulting higher tax burden risks driving away the foreign capital that fuels market liquidity, equity valuations, and domestic investor confidence. As the upcoming budget looms, policymakers face a critical decision about whether to maintain current tax levels or consider modifications that could help restore India's competitiveness in the global capital allocation landscape.