Examine how tax exemptions on FPI investment in Government Securities are used as instruments to attract foreign capital. What are the associated risks?

Q. Examine how tax exemptions on FPI investment in Government Securities are used as instruments to attract foreign capital. What are the associated risks? (15 marks, 250-350 words)

Tax exemption on Foreign Institutional Investor income from Government Securities (G-Secs) is a fiscal signalling tool: by removing the tax wedge on returns, the sovereign lowers its own borrowing cost. The Taxation and Other Laws (Amendment) Bill, 2026 exempts interest and capital gains of FIIs and the Bank for International Settlements on G-Secs from 1 April 2026 [1], making this instrument current and examinable.

How exemptions attract capital

• Raising post-tax yield: interest previously taxed at 20%, short-term gains at 30% and long-term gains at 12.5% now accrue tax-free, directly widening the spread over comparable sovereign debt [1].
• Complementing regulatory liberalisation: exemptions work alongside the RBI's Fully Accessible Route (2020), which opened "specified securities" to unrestricted non-resident holding [2]; tax relief converts market access into actual inflows.
• Global index eligibility: tax-free, unrestricted G-Secs qualify for global bond indices, attracting passive institutional money; extension to the BIS signals sovereign-grade credibility [1].
• Policy certainty: replacing the June 2026 Ordinance with a statute gives investors predictability — the very "certainty" argument that reduces sovereign risk premia [1].

Associated risks

• Hot-money volatility: the RBI's Financial Stability Report, June 2026 notes portfolio flows are most sensitive to global risk sentiment, with outflows reaching up to 3.2% of GDP in an adverse scenario, and net FPI outflows of about US$10 billion in early 2026-27 [3].
• Revenue forgone: exemptions are tax expenditure, disclosed annually in the Receipt Budget's Statement of Revenue Impact of Tax Incentives [4]; benefits must exceed this fiscal cost.
• Loss of monetary autonomy: large debt inflows appreciate the rupee, complicate sterilisation and raise external vulnerability.
• Equity and treaty-abuse concerns: resident investors remain taxed, and exemptions invite round-tripping unless reporting conditions are enforced.

Tax exemption is therefore a legitimate but conditional instrument — effective for deepening the G-Sec market, risky if it substitutes for macro fundamentals. Pairing it with the Voluntary Retention Route's lock-in logic, robust reporting, and periodic cost-benefit review in the Receipt Budget can secure stable long-term capital while protecting fiscal space and financial stability.

(~330 words)

Sources: 1. The Taxation and Other Laws (Amendment) Bill, 2026 — PRS Legislative Research — FII/BIS exemption on G-Sec interest and capital gains from 1 April 2026, pre-existing 20%/30%/12.5% rates, replacement of the Income-tax (Amendment) Ordinance, 2026 2. RBI, 'Fully Accessible Route' for Investment by Non-residents in Government Securities (2020) — unrestricted non-resident access to specified securities from 1 April 2020 3. RBI, Financial Stability Report, June 2026 — portfolio outflows up to 3.2% of GDP in adverse scenario; ~US$10 billion net FPI outflows in 2026-27 so far 4. Statement of Revenue Impact of Tax Incentives under the Central Tax System, Receipt Budget — annual parliamentary disclosure of revenue forgone through tax incentives