India’s Capital Gains Tax On FPIs Reduces Returns, Adds To Cost Of Investing

India’s capital gains tax framework for foreign portfolio investors (FPIs) reduces annual post-tax returns by as much as 2.4 percentage points over a five-year investment period, according to a strategy report released by IIFL Capital. The brokerage said the existing tax structure creates an additional hurdle for overseas investors and recommended that the levy on FPI equity investments be removed.

Invest in Indian Markets and Unlock Future Potential With 5paisa!

Open Account Now

The report, titled Axe the Capital Gains Tax (on FPI equities), argues that India remains the only major equity market that imposes a source-based capital gains tax on foreign portfolio investors. According to IIFL Capital, this results in double taxation in several cases, lowers benchmark returns for overseas funds and increases the overall cost of capital for the country.

Lower Post-Tax Returns For Overseas Investors

According to the brokerage, a domestic investor earning an annual return of 13% would generate a post-tax internal rate of return of about 10.9%. An overseas investor with the same pre-tax return would receive only about 8.4% after accounting for India’s capital gains tax and limitations in claiming tax credits in several jurisdictions.

The report said the issue extends beyond the tax rates themselves. Many global investment funds are required to make daily provisions for taxes on unrealised gains, which reduces their net asset values before the tax liability is actually settled. This can influence portfolio performance and, in turn, the related share price of investment products tracking Indian equities.

India Compared With Other Markets

IIFL Capital noted that countries such as the U.S., Singapore, the UK, Taiwan and the UAE generally do not impose capital gains tax on foreign portfolio investors. In contrast, India currently taxes long-term capital gains at 12.5% and short-term gains at 20%, with surcharge and cess increasing the effective tax burden.

The report also highlighted that several overseas investors, including pension funds, sovereign wealth funds and endowments, may not be able to offset Indian taxes because they either have no tax liability in their home countries or the tax is paid at the fund level rather than by the individual investor.

Impact On India-Focused Investment Products

According to IIFL Capital, the tax structure contributes to a wider performance gap between India-focused exchange-traded funds (ETFs) and their benchmark indices. The brokerage estimated the average difference at around 2.8 percentage points, compared with roughly 0.4 percentage points for ETFs tracking other major markets.

It said the gap can make India-focused passive investment products less competitive when international investors compare returns across markets. This may also affect fund flows into products linked to the share price performance of Indian listed companies.

Recommendation And Fiscal Impact

The brokerage estimated that eliminating the tax would reduce government revenue by around 15-20 basis points of GDP. However, it said the revenue impact could be managed through broader fiscal consolidation instead of increasing the securities transaction tax.

According to the report, removing the capital gains tax on FPIs would complement recent policy measures aimed at attracting overseas capital and could improve India’s competitiveness in global equity markets by reducing structural costs for foreign investors.