What the Government Did — In Plain Terms

India just made it completely tax-free for foreign investors to earn money from Indian government bonds. No tax on the interest they receive. No tax on any profit they make when they sell those bonds. This applies from April 1, 2026.

The action was taken urgently — via an Ordinance on June 5, 2026, bypassing Parliament (which was not in session) under Article 123 of the Constitution. It amends the Income-tax Act and takes immediate effect. A compliance formality — foreign investors must register the exemption in a prescribed format — is pending notification, but the intent and legal force are clear.

The exemption also extends to the Bank for International Settlements (BIS) — the central bank of central banks — signalling India's ambition to be treated as a mainstream, reserve-manager-friendly sovereign debt market alongside the US, Germany, and Japan.  

The Context — Why Foreign Investors in Indian Bonds Pay Tax at All

When a foreign investor — a pension fund in London, a sovereign wealth fund in Singapore, a bond index tracker in New York — buys an Indian Government bond, they are lending money to the Indian Government. In return, the Government pays them interest every six months and returns the principal at maturity.

In most countries — the US, Germany, Japan, most of Europe — foreign investors pay no local tax on this interest income. They pay tax only in their home country, if at all. India was an outlier: it deducted tax from foreign investors' interest payments before they even received them, and taxed any profit they made when selling bonds in the secondary market.

The result: India's Government bonds offered a headline yield of, say, 6.9%. But foreign investors were only receiving ~5.5% after tax — making Indian bonds look far less attractive than competing bonds from other emerging markets that carried no such tax burden. India was competing with one hand tied behind its back.

What Was — The Two Taxes That Deterred Foreign Money

Tax 1: Withholding Tax on Interest — 20%

Every time a foreign investor received interest on an Indian Government bond, 20% was automatically deducted before the payment reached them. This is called a withholding tax — the government withholds it at source, so the investor never sees that money. 

On a bond yielding 6.9%, a 20% withholding tax reduced the investor's actual receipt to approximately 5.5%. That 1.4% gap — on a large portfolio — is the difference between India being an attractive destination and being passed over in favour of bonds from Indonesia, Mexico, or South Africa where such taxes are lower or absent.

Tax 2: Capital Gains Tax — 12.5%

If a foreign investor bought an Indian Government bond and later sold it at a higher price (because interest rates fell and bond prices rose), they owed tax on that profit — 12.5% for bonds held more than a year, 20% for bonds held less than a year.

This may sound reasonable, but it created a practical problem: most large global bond funds trade actively, adjusting their portfolios as interest rate expectations change. Every time they sold an Indian bond at a gain, a tax bill followed. This made India a costly market to trade in — so many funds simply held fewer Indian bonds, or avoided them entirely. India was one of only a handful of countries in the world that taxed foreign investors on capital gains from government bonds.

What Is Now — Both Taxes Gone

The Ordinance eliminates both taxes in their entirety for foreign investors in Government Securities. The before-and-after is stark:

The exemption covers the full range of Central Government bonds — both FAR-designated securities and those under the General Route — as well as Treasury Bills. 

How Much Foreign Investors Gain — The Numbers

Foreign investors currently hold INR 3,80,487 crore (approximately $46 billion) of Indian Government bonds across both the FAR and General Routes. Using the weighted average yields on these holdings, the annual tax saving from the exemption can be estimated:

How the numbers are derived: FPI holdings of INR 3.8 lakh crore earn roughly INR 26,000–27,000 crore in interest annually. At 20% withholding, the tax deducted was ~INR 5,200–5,400 crore. The INR 4,000–5,000 crore estimate is slightly conservative — some investors had reduced rates via tax treaties. Capital gains estimates reflect secondary market trading activity; this number will grow as participation deepens.

The Government's Trade-Off — Revenue Foregone vs. Borrowing Saved

The same INR 4,500–6,000 crore that foreign investors gain is money the Indian Government is giving up in tax revenue. This is a deliberate choice — and the arithmetic makes it an easy one.

What the Government gives up: INR 4,500–6,000 crore per year in foregone tax revenue from existing FPI holdings.

What the Government stands to gain: If the exemption attracts significantly more foreign money into Indian Government bonds, and that demand drives even a modest 0.25–0.50% reduction in the yield at which the Government borrows, the interest saving on the total outstanding stock of Central Government securities is enormous. A 0.50% saving on INR 5 lakh crore of outstanding bonds = INR 25,000 crore per year in lower interest payments — more than four times the tax revenue foregone.

Put simply: the Government is giving up INR 6,000 crore in tax to potentially save INR 25,000 crore in interest costs. That is not a difficult trade-off. 

Broader Implications

India Becomes Competitive Globally

At 6.9% with zero tax, Indian Government bonds now offer one of the highest after-tax yields among major sovereign bond markets in the world. Indonesia, Brazil, and South Africa — India's main competitors for foreign bond investors — all retain some form of withholding tax on interest. India has gone from being tax-disadvantaged to tax-advantaged in a single Ordinance. 

The Index Fund Effect

Trillions of dollars in global money are managed by funds that simply track bond indices — the JPMorgan GBI-EM, Bloomberg EM Local Currency, and FTSE indices. These funds must buy bonds in proportion to the index. Here is the important technical detail: these indices calculate returns based on the full gross yield. When a fund was paying 20% withholding tax on interest, it was consistently underperforming its benchmark. That gap made India a drag on fund performance — a structural reason to underweight Indian bonds.

With the withholding tax gone, the fund receives the same yield the index assumes. India stops being a benchmark drag. As index weights are recalculated — particularly with FAR now including long-tenor bonds — the mechanical, rules-based flows into Indian G-Secs will increase. This is automatic demand that does not depend on any fund manager making a discretionary decision.

Active Investors Can Now Trade Freely

Previously, a fund manager who bought an Indian Government bond and later wanted to sell it — perhaps because they expected interest rates to rise — had to factor in a 12.5% capital gains tax on any profit. This made India an expensive market to trade actively, so most foreign investors simply held their bonds statically and collected the coupon. Now, with zero capital gains tax, they can buy and sell Indian bonds as freely as they would US Treasuries or German Bonds. More active trading means deeper, more liquid markets — which in turn makes Indian bonds more attractive to yet more investors.

A Decade-Long Grievance Removed

For over a decade, in every investor roadshow, in every emerging market fixed income conference, the two questions that came up about India were: 'Why is there a withholding tax on government bond interest?' and 'Why are foreigners taxed on capital gains from sovereign bonds?' These were India's most persistent structural disadvantages relative to peer markets. Both are now gone — in a single day, retrospectively from April 1. The signal to global investors is unambiguous. 

Summary

India has eliminated both the 20% withholding tax on interest and the capital gains tax on Government Securities for foreign investors, effective April 1, 2026. On the existing INR 3.8 lakh crore FPI holding base, this means INR 4,500–6,000 crore more in foreign investors' pockets annually. For India, the INR 6,000 crore in foregone tax revenue is a deliberate trade for potentially INR 25,000 crore in lower annual borrowing costs as foreign demand for G-Secs grows. The deeper consequence: a decade-long structural disadvantage is removed, index-tracking funds stop being penalised for holding Indian bonds, and active investors gain the freedom to trade — making India's Government bond market deeper, more liquid, and more globally integrated.

Source: SBI Research Paper