The reported proposal to exempt foreign portfolio investors (FPIs) from long-term capital gains (LTCG) tax has revived a familiar debate about the taxation of investment income. The concern about the cumulative tax burden on equities is legitimate, but the proposed exemption is misguided. The underlying problem is India’s fragmented taxation of corporate profits, shareholder returns, and securities transactions.
The mistake of retaining STT
A fundamental principle of income taxation is that business profits should bear broadly comparable tax burdens whether earned through a proprietorship or an incorporated company. A proprietor pays personal income tax directly on business profits. A company first pays corporate income tax, after which shareholders may pay tax on dividends or realised capital gains. In addition, securities transaction tax (STT) applies to specified transactions on recognised exchanges. The combined burden of corporate and shareholder income taxes should broadly correspond to the top marginal personal income-tax rate on comparable business profits, rather than penalising or favouring incorporation.
STT was introduced in 2004 as a replacement for LTCG tax on listed equities. The original proposal envisaged a transaction tax of 0.15%, but market opposition forced the government to introduce differentiated and substantially lower rates for certain transactions. Contemporary estimates suggested that the original proposal could generate approximately Rs 7,000 crore annually, but the revised design substantially reduced the expected yield. Collections at the two principal stock exchanges in 2004-05 were only about Rs 516 crore, although the levy operated for just six months. The figures are not strictly comparable, but the experience illustrates the consequences of the rollback.
More fundamentally, STT is levied on transaction value irrespective of whether an investor makes a profit or suffers a loss. It creates cascading costs through successive transactions, discourages portfolio rebalancing and risk-taking, and can reduce market liquidity. The ability to collect a tax conveniently does not establish its economic desirability. Except in extraordinary circumstances, a transaction tax has little place in a sound income-tax system.
When LTCG taxation was reintroduced in 2018 at 10%, the government nevertheless retained STT. The increase in the capital gains rate to 12.5% in 2024 further aggravated the cumulative burden. The tax originally introduced as a substitute had become an additional levy. The appropriate response is to abolish STT, not to exempt capital gains from income tax.
Taxing shareholder returns
The taxation of dividends and capital gains presents a more fundamental problem of corporate-shareholder integration. Dividends are distributed from profits that have already borne corporate income tax. Capital gains can similarly reflect accumulated after-tax profits retained within a company, although share prices also reflect expectations of future earnings. Ideally, dividends would be included fully in shareholders’ taxable income, with credit for corporate income tax attributable to those profits. Corresponding treatment would be necessary for capital gains. Such a system would preserve progressivity while avoiding excessive taxation of income earned through the corporate form.
However, determining the exact corporate-tax credit attributable to individual shareholders would be extraordinarily complex. Companies face different effective tax rates, accumulate profits over several years and have changing shareholders. Tracing taxes already paid through retained earnings and share valuations would entail substantial administrative and compliance costs. A theoretically elegant system could therefore become exceptionally difficult to implement.
A practical compromise would be to allow a standard deduction of 50% of dividends and realised long-term equity capital gains, with the remaining 50% taxed at the shareholder’s applicable personal income-tax rate. The deduction would serve as a simplified proxy for corporate income tax already paid, rather than an exact credit. It deliberately sacrifices some theoretical precision in favour of simplicity, certainty and ease of administration. Unlike the present flat 12.5% rate on eligible equity gains, it would also preserve progressivity.
At marginal personal income-tax rates of 5, 10, 15, 20, 25, and 30%, the corresponding effective shareholder-level rates would be 2.5, 5, 7.5, 10, 12.5, and 15%, respectively, before surcharge and cess. Investors with higher taxable incomes would therefore face higher marginal tax rates on shareholder returns. Although the 50% deduction cannot guarantee exact neutrality between incorporated and unincorporated businesses at every income level, it provides a transparent and administratively feasible approximation.
The anomaly in corporate-bond taxation
The taxation of corporate bonds requires a fundamentally different approach. Unlike dividends, which are distributed from post-tax corporate profits, interest paid on corporate bonds is ordinarily deductible in computing the issuing company’s taxable income. Consequently, there is no justification for extending the proposed 50% deduction to interest income. Interest should continue to be taxed in full at the recipient’s applicable personal income-tax rate.
The concessional 12.5% tax on LTCG from qualifying listed corporate bonds creates an unjustified distinction: interest is taxed at the investor’s applicable personal income-tax rate, while capital appreciation receives preferential treatment. Both represent returns on debt investment and should be taxed at the investor’s applicable personal rate, without the proposed 50% equity deduction. Such symmetrical treatment would also discourage the conversion of ordinary interest into concessionally taxed capital gains.
More fundamentally, interest is deductible in computing corporate taxable profits, whereas dividends are distributed from post-tax profits. This creates an inherent tax bias in favour of debt financing, encouraging excessive leverage and increasing the risk of financial distress and bankruptcy. The proposed 50% deduction for dividends and equity capital gains, while subjecting returns on corporate bonds to full personal taxation, would partly offset this bias. Although it would not eliminate the underlying distortion arising from interest deductibility, it would reduce the tax incentive to finance investment through debt rather than equity.
Alternative framework
FPIs raise a separate issue concerning the measurement of taxable gains. The Income Tax Act, 2025, preserves foreign-currency computation for certain non-residents but excludes securities gains under the special FPI regime. Consequently, an investor may face tax on capital gains measured in rupees even when no gain has accrued in the currency originally invested. This is an anomaly in measuring taxable income, not a justification for exempting it. Foreign-currency computation should be extended to these investors, with symmetrical treatment of exchange gains and losses.
Exchange-rate arrangements can introduce another distortion. Where exchange rates are administratively regulated and investors must convert foreign currency at rates less favourable than market-clearing rates, an implicit tax may arise. This possibility is distinct from India’s present market-determined exchange-rate framework. It nevertheless illustrates why the effective taxation of foreign investment must be assessed by considering both the statutory tax burden and the treatment of exchange-rate movements.
An alternative framework would therefore rest on four reforms: abolish STT; tax half of dividends and long-term equity gains at the shareholder’s applicable personal income-tax rate; subject interest and capital gains on corporate bonds to ordinary personal taxation without a deduction; and permit appropriate foreign-currency computation for FPIs. Together, these measures would reduce distortions between dividends and capital gains, between debt and equity, and between domestic and foreign investment.
The purpose of tax policy is not to guarantee attractive returns to stock-market investors. Share prices should reflect corporate profitability, productivity, innovation, governance, and the broader performance of the economy. Tax concessions designed to offset disappointing market returns risk distorting investment decisions without improving the underlying fundamentals. The objective of tax reform should be to eliminate distortions and anomalies, not to prop up stock markets. Markets should perform on the strength of corporate fundamentals and the broader economy, not on the generosity of tax concessions.
The writer is Senior Visiting Research Fellow, XKDR, Mumbai; former Member, CBDT; and former Senior Economist, IMF
Disclaimer: The views expressed are the author’s own and do not reflect the official policy or position of Financial Express.
This article was first uploaded on November six, twenty twenty-six, at forty-seven minutes past nine in the night.
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