India must scrap capital gains tax on foreign investors

‘Investment is an act of faith and profit is the reward for risk-taking’ – Manmohan Singh, 1993.

India is a developing country with an average demographic age of ~29 years, population of ~1.4 billion, a per capita income of ~USD 3,000 and decades of opportunity and growth ahead.

At this stage of its development, India needs large pools of capital to invest in its infrastructure, development, and growth.

At its per-capita income level, with high fiscal deficit, and debt to GDP ratio, India does not have enough domestic capital to achieve its ambitions.

The Mathematics of the 8% Growth Gap

India’s domestic savings to GDP ratio is ~30%. As I explained in India’s Nominal Growth Concern, assuming savings=investments, at an ICOR (Incremental Capital to Output Ratio) of 5, this domestic savings can help achieve as ~6% (30/5) rate of real GDP growth.

We know from global growth history of countries like Japan, South Korea, China who graduated from lower income to middle/higher income during their demographic dividend phase, countries need to be able to grow at 8-10% real rates of growth for a sustained period.

For that you need a higher rate of investment to GDP ratio. Assuming the ICOR remains at 5, to be able get 8% real GDP growth, India’s investment to GDP rate needs to be 40% of GDP.

India needs 5% of GDP in Annual global capital Inflows

Even if domestic savings rate rises, we still have a gap to fill in to increase the investment rate. This gap is filled by attracting global capital to invest into India.

India should be attracting global capital flows of ~5% of GDP annually as FDI (Foreign Direct Investments, Private Investments into companies), FPI (Foreign Portfolio Flows), ECB (External commercial borrowings) and multi-lateral flows into its markets – equities, bonds, private companies, start-ups, real estate and infrastructure projects.

India realized this and in the 1990’s and subsequent decades opened its economy and markets to attract global capital. However, as the chart above suggests, despite the opportunity and potential, India has not attracted as much global capital it deserves. Only once in the last 35 years capital flows have been above 5% of GDP and Investment rate >40% of GDP.

Now there are several reasons for the inability to attract large global capital investments – rule of law, policy certainty, governance, return expectations and outcomes etc. However, I want to focus on a simple and specific issue of Capital Gains and withholding taxes on foreign investors.

Frictional Costs: Why Global Investors are Under-weighted

India re-introduced capital gains tax on listed equity securities in 2018 and increased the capital gains tax rate in 2024. This was done for both domestic and non-resident (foreign) investors. Currently, the capital gains tax on listed securities if sold before 1 year is 20% and if held above 1 year is 12.5% (plus applicable surcharge and cess).

Over these years, India has also removed capital gains tax exemption present in almost all bilateral tax treaties. Ajay Shah, the noted economist, has a very good piece tracing the The value of the Mauritius treaty in terms of its history, relevance, and the rationale for tax exemption for foreign investors and discusses the impact of the recent ruling on Tiger Global’s India investments.

Many have argued that India should also follow the global norm of residence-based taxation system. The investor should be taxed in their home country instead of being forced to pay capital gains taxes or withholding taxes in the source country where the gains/income are accrued.

1. It creates friction: The foreign investor is subject to and must deal with the administrative requirements of being taxed in a foreign country.
2. No set-off for a non-taxable investors: Many global institutional investors like Sovereign Wealth Funds, Public Pension Funds, Foundations etc are non-taxable investors in their home country. So, the tax paid in India for these investors cannot be set-off against other taxes due in their home country. Their effective post tax return from India is thus lower by the extent of the tax rate.
3. Double Taxation: This is indeed a big issue for taxable investors who invest in a Fund which invests in Indian listed equity securities. The Fund accrues and pays the capital gains tax in India thus lowering the post tax return for the investor. When the investor redeems their investments from the Fund, they may be subject to capital gains in their home country. In most cases, that investor may not get sufficient credit for the tax already paid by the Fund. Hence, that investor faces double-taxation on their investments in India.
4. Capital Gains on Rupee Value, NAV in foreign currency: India taxes capital gains on the rupee value of the gain. Once the tax is paid, the value/gains are repatriated/translated into the base currency of the investor/Fund. If the Indian rupee depreciates against the foreign currency (which has been the long-term reality against most currencies), the repatriated/translated value of the investment is further lowered in the foreign currency. The foreign investor thus incurs a much higher rate of effective tax when seen as returns in their home currency.
5. It increases the required rate of return: Given the incidence of capital gains taxation, the foreign investor expects a higher rate of return before investing in Indian equities. As the chart below shows, cumulative net flows from foreign investors into Indian equities since 2018, when capital gains tax was introduced is only USD 22 billion. Capital gains tax is a big reason for this.

One would argue that all the above points hold true for withholding tax on interest income/dividends on bonds/investment trusts etc. We can make the same case for capital gains taxation on investments in private business / unlisted entities.

India should not be taxing genuine regulated foreign investors investing into its capital markets, businesses and or helping build the physical infrastructure.

Residence based taxation system

Most OECD nations (Organisation for Economic co-operation and development) do not impose capital gains tax on foreign investors. They follow the residence-based taxation system. Only on certain assets like real estate beyond a threshold or underlying business in natural resources may see some instance of capital gains tax. Other than that, these countries do not cause friction to attract foreign investor interest.

However, do note that almost all of them have capital gains tax for their own domestic residents. Now, think about the fact that these countries, unlike India, do not necessarily need that foreign capital for their growth and development. Yet, they do not subject the foreign investor to their tax system.

And here we are, despite the need to attract lot of global foreign capital, we subject the foreign investor to our tax administrative system. As the recent, Tiger Global investments and tax case depicts, and with many such prior instances, Indian tax policies do not always offer the certainty and the fairness.

The administrative friction, the double taxation, the post tax impact of depreciating currency all combines to increase the threshold expected rate of return and prevents global capital from allocating more money into India.

The government needs to think long-term and weigh the benefits of some tax revenues against the possibility of attracting much need foreign capital into its capital markets, businesses, and infrastructure.

The choice should be obvious.

Given that foreign investments, FDI and FPI have seen net outflows and that foreign investors are anyways under-invested in India, we think a simple removal of capital gains tax or removal with some thresholds will go a long way in attracting global capital back to India at a level which India deserves and warrants given the simple, predictable long-term India opportunity.

The time is also ripe. I started this Global India Insight series with a piece on how a global reset will lead to global rebalance of investment portfolios. Investors will look for large investment destinations which offer a rule-based, democratic, trusted investment opportunity. India has and offers all of the above and it can improve its appeal by offering a simple tax system which global investors cannot resist.

Disclaimer:

Arvind Chari is a Chief Investment Strategist and has been with Quantum Advisors India group since 2004. Arvind has over 20 years of experience in long-term India investing across asset classes. Arvind is a thought leader and guides global investors on their India allocation.

This article is for educational and discussion purposes only and is not intended as an offer or solicitation for the purchase or sale of any investment in any jurisdiction. No advice is being offered nor recommendation given and any examples are purely for illustrative purposes. The views expressed contain information that has been derived from publicly available sources that have not been independently verified. No representation or warranty is made as to the accuracy, completeness, or reliability of the information.

The views and opinions expressed in this article are my personal views and should not be construed of the Firm. There is no assurance or guarantee that the historical result is indicative of future results, and the future looking statements are inherently uncertain and cannot assure that the results or developments anticipated will be realized.