Closing the Tax Gap in India’s Sovereign Debt Market: Analysing the FII Exemption Under the Income-tax (Amendment) Ordinance, 2026
Introduction
On 5 June 2026, the Government of India promulgated the Income-tax (Amendment) Ordinance, 2026, introducing a significant change to the tax treatment of foreign investments in Government Securities (G-Secs). The Ordinance exempts Foreign Institutional Investors (FIIs) and the Bank for International Settlements (BIS) from income tax on interest income and capital gains arising from investments in Government Securities, with effect from 1 April 2026.
The measure comes at a time when policymakers are seeking to deepen India’s bond markets, attract long-term foreign capital and enhance the competitiveness of Indian Government Securities relative to other major emerging markets.
While the amendment appears straightforward, its significance becomes clearer when viewed against the taxation framework established under the Income-tax Act, 2025.
The Existing Tax Framework for FIIs
The Income-tax Act, 2025 contains a dedicated taxation regime for Foreign Institutional Investors under Section 210. According to the Government’s FAQs, Section 210 governs taxation of income from securities and capital gains arising from their transfer.
Section 210(6)(a) defines a “Foreign Institutional Investor” as such investor as may be notified by the Central Government. Foreign Portfolio Investors registered with SEBI under the SEBI FPI Regulations have already been notified for this purpose.
The FAQs further explain that, prior to the Ordinance, the applicable tax rates under Section 210 included:
- 20% on income in respect of securities;
- 30% on short-term capital gains not covered by Section 196;
- 20% on short-term capital gains covered by Section 196;
- 12.5% on long-term capital gains not covered by Section 198; and
- 12.5% on long-term capital gains covered by Section 198 above the prescribed threshold.
Accordingly, in the absence of a specific exemption, interest income and capital gains arising from investments in Government Securities remained taxable in the hands of FIIs.
Why Government Securities Faced a Tax Disadvantage
The practical issue arose because Government Securities generally do not attract Securities Transaction Tax (STT). The Government’s FAQs specifically note that transactions in Government Securities ordinarily fall outside the STT framework.
This had an important consequence.
Sections 196 and 198 of the Income-tax Act, 2025 provide concessional capital gains treatment where specified STT-related conditions are satisfied. Since STT is generally not payable on Government Securities, transfers of Government Securities by FIIs ordinarily did not qualify for these concessional provisions.
As a result:
- Short-term capital gains on Government Securities were generally taxable at 30%; and
- Long-term capital gains were generally taxable at 12.5%.
The FAQs expressly acknowledge this position and identify it as the backdrop against which the exemption has been introduced.
Classification of Government Securities as Capital Assets
The Income-tax Act, 2025 treats securities held by FIIs as capital assets. Section 2(22)(b) includes securities held by a Foreign Institutional Investor within the definition of “capital asset”.
The holding period determines whether gains are short-term or long-term.
Under Section 2(101):
- A listed Government Security becomes a long-term capital asset if held for more than 12 months.
- An unlisted Government Security becomes a long-term capital asset if held for more than 24 months.
The Government’s FAQs reiterate this distinction and explain the resulting tax consequences under Section 210.
The Ordinance: Introduction of Complete Tax Exemption
The Income-tax (Amendment) Ordinance, 2026 amends Schedule IV of the Income-tax Act, 2025 by inserting new Serial Numbers 13D and 13E.
The newly inserted entries exempt:
- Any interest on Government Securities; and
- Any capital gains arising from the sale, exchange or transfer of Government Securities.
The exemption is available to:
- Foreign Institutional Investors; and
- The Bank for International Settlements.
The exemption is subject to furnishing information in the prescribed form and manner.
Importantly, the Ordinance provides that it shall be deemed to have come into force on 1 April 2026, thereby extending the benefit to income arising from the commencement of the new Income-tax Act, 2025 regime.
Parallel Reforms to Encourage Foreign Participation
The tax exemption was announced alongside several reforms relating to foreign participation in Government Securities.
According to the Ministry of Finance, the Government has:
- Expanded the list of securities eligible under the Fully Accessible Route (FAR);
- Included certain longer-tenor Government Securities and Sovereign Green Bonds within the FAR framework;
- Removed certain investment restrictions applicable to FPI investments under the General Route; and
- Rationalised the tax treatment of Government Securities by exempting interest and capital gains.
The Government has stated that these measures are intended to deepen the Government securities market, facilitate a smoother yield curve, and attract long-term institutional investors such as pension funds, insurance companies and sovereign wealth funds.
Impact on Foreign Investors
The amendment effectively removes the principal tax costs previously associated with investments in Government Securities by FIIs.
Following the Ordinance:
- Interest income from Government Securities becomes exempt;
- Short-term capital gains become exempt;
- Long-term capital gains become exempt; and
- The distinction between gains qualifying or not qualifying under Sections 196 and 198 becomes largely irrelevant for Government Securities held by FIIs.
The reform therefore represents a shift from preferential taxation to complete exemption in respect of Government Security investments.
Conclusion
The Income-tax (Amendment) Ordinance, 2026 read together with the Government’s parallel reforms to the foreign investment framework for Government Securities, reflects a policy decision to position India’s sovereign debt market as a more attractive destination for global institutional capital. By removing tax on both interest income and capital gains for FIIs, the Government has sought to address a long-standing concern regarding the tax cost of investing in Indian Government Securities and to support deeper foreign participation in the domestic bond market.
Disclaimer: The views expressed herein are solely for legal research purposes and do not constitute legal opinion, legal advice, solicitation, or professional guidance of any nature. The views are personal to the author and do not necessarily reflect those of PJ Law Offices (www.pjlaw.in), its principal, representatives, associates, retainers, affiliates (collectively, “PJLaw”). Readers are advised to seek independent legal counsel before acting on any information contained herein. PJLaw makes no representation or warranty, express or implied, regarding the accuracy or completeness of the contents and expressly disclaims all liability arising from reliance upon or use of the same.
