With capital outflows eroding India’s foreign exchange reserves by nearly $38 billion since March this year amid the West Asia conflict, the government is reportedly considering slashing the ‘withholding tax’ rate from 20% to the earlier 5% as it looks to revive overseas inflows.
Withholding tax, akin to a tax deducted at source, is paid by foreign investors on the interest they earn on their holding of Indian bonds.
A high withholding tax is seen as a major deterrent for foreign capital inflows at a time when India is grappling with rising external pressures, including a sharp surge in crude oil prices.
The move assumes significance as the government has already proposed several measures to curb outflows and manage the external account, including cuts in expenditure and restrictions on foreign travel, gold imports and other non-essential spending.
Market participants believe that lowering the withholding tax could improve post-tax returns for foreign investors, make Indian debt and other financial assets more attractive, and help stabilise forex reserves amid heightened global uncertainty.
What is withholding tax?
Withholding tax, or WHT, is a tax collected at the source of income. Instead of waiting for an investor or foreign company to pay taxes at the end of the financial year, the government requires the payer to deduct a portion of the income before it is remitted to the recipient.
The deducted amount is then directly deposited with the government. In simple terms, whenever income is earned — whether through employment, investments, royalties or other sources — the government ensures tax collection in advance through withholding tax.
When was the withholding tax rate hiked?
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India had introduced a concessional 5% withholding tax rate on interest earned by foreign investors from investments in government securities and certain rupee-denominated bonds under Section 194LD of the Income Tax Act.
However, the concessional regime expired in July 2023. Following its expiry, the withholding tax applicable to many foreign investors effectively reverted to around 20%, making India one of the relatively higher-tax jurisdictions for global bond investors. Analysts say the higher tax burden reduced the attractiveness of Indian debt instruments at a time when the country was also seeking greater foreign capital inflows and inclusion in global bond indices.
India’s withholding tax regime has also evolved significantly over the decades in other areas. In 1976, withholding tax on royalties paid to non-residents was fixed at 40%, while fees for technical services (FTS) attracted a 20% levy. Between 1986 and 2005, the government sharply reduced the withholding tax rate on both royalties and technical services to 10% in an effort to lower technology acquisition costs for Indian companies and encourage foreign collaboration.
How will slashing withholding tax affect FPIs?
The withholding tax reduces foreign portfolio investors’ (FPIs) effective yields and overall investment returns because it is deducted at the source before interest, dividends or other investment income is remitted to them. This compresses investors’ post-tax returns, weakens the power of long-term compounding and limits the amount of capital available for immediate reinvestment.
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For large global investors operating across multiple jurisdictions, such deductions can also create short-term liquidity constraints by locking up funds until tax credits or refunds are processed.
In addition, FPIs often face significant administrative and compliance burdens in claiming relief under Double Taxation Avoidance Agreements (DTAAs). Higher withholding taxes may therefore reduce the attractiveness of a market by increasing transaction costs, lowering risk-adjusted returns and creating regulatory friction for overseas investors.
Do other countries impose such a tax?
Most countries impose some form of withholding tax on foreign investors, especially on passive income such as dividends, interest and royalties. However, the rates, scope and exemptions vary widely depending on the country, the type of investor and whether a DTAA exists with the investor’s home country. The US imposes a 30% tax, Germany 26.4%, France 25% and China 10%. Hong Kong and Singapore don’t have a withholding tax.
How much do FPIs invest in government debt?
FPIs hold a relatively small share of India’s government debt market, though their exposure has risen sharply after India’s inclusion in global bond indices such as the JPMorgan Government Bond Index-Emerging Market. The Reserve Bank of India has kept the FPI investment cap in government securities at 6% of outstanding stock.
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At the end of March 2025, FPI investment in dated securities jumped by 43.2% to 43.9 billion from its level of 30.6 billion at end-March 2024.
Why are there demands for eliminating or cutting this tax?
Analysts say inclusion in global bond indices was delayed by taxation and procedural hurdles such as the high withholding tax. This suggests foreign inflows could rise significantly if the government reduces withholding tax on investments and simplifies related processes. Interest tax of 20%, higher than in most peer jurisdictions, also reduces the relative attractiveness of Indian debt.
“Both Global Agg and FTSE WBGI seek clarity or exemption on taxes. The inclusion could imply $45-50 billion of inflows over two years, and greater allocation from pension funds/endowments not using these as benchmarks but taking comfort from inclusion and the clarity on taxation. Several major nations do not tax bond investments, and even those that do, like China, gave a special dispensation to investors that entered after index inclusion (tax exemption granted has so far been extended repeatedly),” said a report by Prateek Ancha, Senior Vice President, Axis Bank.
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Besides capital gains tax (short and long-term), interest income typically attracts a 20% rate, after the concessional WHT facility was phased out in mid-2023. Debt category has witnessed FPI outflows worth $613 million in FY27 so far, after $2.8 billion inflows in FY26, under the general limit, VRR and FAR windows, said Radhika Rao, Senior Economist and Executive Director, DBS Bank.
