Foreign investors need a sufficiently deep and liquid domestic market that allows them to trade in large volumes without triggering sharp price movements or incurring substantial losses | Photo Credit: Doucefleur
With the interest-rate differential between India and the US hovering near historic lows, raising domestic rates to support the rupee is an option. But it comes at a cost.
Higher borrowing costs will squeeze corporate margins, weaken earnings growth and can weigh on equity markets. A less costly alternative is to correct the tax disadvantage faced by debt funds and make corporate debt more attractive to foreign portfolio investors.
Liquidity is key
Buying individual corporate bonds and holding them until maturity is not always practical, especially for funds managing substantial portfolios. Pooled investment vehicles such as debt mutual funds and corporate bond ETFs offer a more convenient route, providing diversified exposure and, in the case of ETFs, the ability to trade on exchanges.
However, their effectiveness depends on the depth of the underlying market. A larger domestic investor base, supported by greater participation in debt funds, can strengthen market liquidity and make India’s corporate bond market more accessible to foreign investors.
India’s tax treatment of debt funds works against this. Gains from specified debt mutual funds acquired on or after April 1, 2023, are treated as short-term capital gains and taxed at the investor’s marginal income-tax rate, irrespective of the holding period. For investors in the highest tax bracket, this can mean a rate of 30 per cent, before applicable cess and surcharge. Equity funds, by contrast, enjoy substantially lower capital gains tax rates: 12.5 per cent on long-term gains and 20 per cent on short-term gains, plus cess and surcharge.
This disparity makes debt funds less attractive to domestic investors. Bringing their tax treatment closer to that of equity funds could incentivise domestic participation, expand assets under management and improve market depth, providing the scale needed to attract foreign capital.
Foreign investors also need a sufficiently deep and liquid domestic market that allows them to trade in large volumes without triggering sharp price movements or incurring substantial losses.
The DTAA advantage
The assumption that foreign investors can route investments through Mauritius or other low-tax jurisdictions to avoid Indian capital gains tax is becoming less dependable. The Principal Purpose Test under the India-Mauritius tax treaty allows tax authorities to deny treaty benefits, which are neither automatic nor free of compliance costs.
The India-US DTAA, for instance, offers no blanket exemption from Indian capital gains tax on Indian assets. Article 13 allows both countries to tax capital gains under domestic law, while Article 25 provides relief from double taxation, subject to US tax rules.
As treaty benefits do not necessarily eliminate Indian tax, the domestic tax regime assumes greater importance in investment decisions. A high tax burden on debt investments can discourage foreign capital, particularly when alternative markets offer better post-tax returns.
Taxing gains
India calculates capital gains on Indian assets in rupees, while foreign investors measure returns in their own currencies, such as the US dollar. If an investor buys an Indian debt asset and sells it at the same dollar value, rupee depreciation during the holding period could still produce a taxable capital gain in rupee terms, despite little or no return in dollars.
This currency-related tax burden makes Indian debt investments less attractive to global funds comparing post-tax returns across markets. A lower tax rate on debt gains would reduce this disadvantage and improve the economics of investing in Indian debt.
India has already recognised the importance of tax incentives in attracting foreign capital.
The recent exemption from income tax on interest and capital gains for eligible foreign investors in government securities provides a precedent. Extending comparable incentives to corporate debt could encourage foreign participation in a market that needs deeper pools of capital.
The objective should be to make Indian debt investments more competitive, not to rely on higher interest rates to compensate for tax disadvantages. Together, these measures can deepen India’s debt markets, improve liquidity and attract foreign exchange inflows.
Any tax cut means a loss of revenue, which would make the Finance Minister hesitant. However, a distortionary tax structure discourages investment in debt funds and prevents the corporate debt market from deepening.
For a country seeking to strengthen its currency and broaden its sources of capital, bringing tax parity between debt and equity funds is a more sustainable approach than raising interest rates, which drive up borrowing costs, or burning through scarce forex reserves.
The writer is author of the upcoming book ‘Earning Well, Not Getting Rich’, to be published by HarperCollins.
Published on November 10, 2026
