India Scraps Capital Gains Tax on FII G-Secs: 2026 Guide

In a landmark move to boost foreign investment in India's debt markets, the government has eliminated capital gains tax on Foreign Institutional Investor (FII) and Foreign Portfolio Investor (FPI) investments in government securities starting April 1, 2026. This policy shift, announced in Budget 2026 and formalized through Finance Act 2026 amendments, positions India as an increasingly attractive destination for global fixed-income investors seeking tax-efficient sovereign debt exposure in emerging markets.

Understanding the Capital Gains Tax Exemption Framework

The Finance Act 2026 introduced a new Section 10(4D) in the Income Tax Act, 1961, which specifically exempts capital gains arising from the transfer of eligible government securities by registered foreign investors. This exemption represents a significant departure from the previous taxation regime where FIIs faced capital gains tax rates ranging from 10% to 30% depending on the holding period and applicable Double Taxation Avoidance Agreement (DTAA) provisions.

Under the earlier framework, short-term capital gains (for securities held less than 36 months) were taxed at applicable rates under DTAA or 30% plus surcharge and cess, while long-term capital gains attracted 10% tax without indexation benefits for foreign investors. The complete elimination of these taxes substantially improves post-tax returns for international institutional investors allocating capital to Indian sovereign debt instruments.

Eligible Securities Under the Exemption

The exemption specifically applies to the following categories of government securities:

• Central Government Securities (G-Secs): All dated securities issued by the Reserve Bank of India on behalf of the Government of India
• State Development Loans (SDLs): Securities issued by state governments through RBI auctions
• Treasury Bills: Short-term instruments with maturities of 91 days, 182 days, and 364 days issued by the central government
• Sovereign Gold Bonds: Subject to specific conditions outlined in CBDT Circular 8/2026 dated May 15, 2026

Notably, the exemption does not extend to corporate bonds, government-guaranteed bonds issued by public sector undertakings, municipal bonds, or any debt securities issued by entities other than sovereign governments. Foreign investors seeking capital gains benefits must ensure their portfolios contain only eligible instruments as defined in the Finance Act 2026 notification.

Eligibility Criteria for Foreign Investors

To benefit from the capital gains tax exemption, foreign investors must satisfy specific regulatory and compliance requirements established by the Securities and Exchange Board of India (SEBI), Reserve Bank of India (RBI), and the Central Board of Direct Taxes (CBDT).

Registration Requirements

Foreign investors must hold valid registration under one of the following categories:

• Foreign Portfolio Investors (Category I, II, or III): Registered with SEBI under the SEBI (Foreign Portfolio Investors) Regulations, 2019
• Foreign Institutional Investors: Legacy FII registrations that remain valid or have been migrated to FPI category
• Sovereign Wealth Funds: Government-owned investment vehicles with specific SEBI exemptions or registrations
• Multilateral Agencies: International financial institutions approved by RBI for investment in Indian debt markets

Documentation and Compliance

To claim the exemption, foreign investors must maintain comprehensive documentation including Permanent Account Number (PAN), Tax Residency Certificate (TRC) from their home jurisdiction, Form 10F declarations, and detailed investment records showing acquisition dates, consideration amounts, and transfer details for each government security transaction. These documents may be required during tax assessments or scrutiny proceedings by Indian tax authorities.

Tax Implications and Computational Framework

While capital gains are now exempt, foreign investors must understand the complete tax treatment of their government security investments to accurately compute total tax liability on their Indian-sourced income.

What Remains Taxable

The exemption under Section 10(4D) applies exclusively to capital gains. The following income streams from government securities continue to attract tax liability:

• Interest Income: Coupon payments received on G-Secs remain fully taxable as "Income from Other Sources" at applicable DTAA rates or 20% plus surcharge and cess
• Discount on Treasury Bills: The difference between issue price and redemption value may be treated as interest income rather than capital gains depending on characterization
• Securities Transaction Tax (STT): While typically not applicable to government securities, any STT if levied remains payable

Practical Examples of Tax Savings

Example 1 - Long-term Investment: A Singapore-based FPI purchases ₹10,00,00,000 worth of 10-year G-Secs in May 2026 at 7.2% coupon. After holding for 4 years, the investor sells the securities for ₹11,50,00,000 in May 2030. The capital gain of ₹1,50,00,000 is completely tax-exempt under Section 10(4D). Under the previous regime, this would have attracted ₹15,00,000 in LTCG tax (at 10%), representing significant tax savings that enhance overall investment returns.

Example 2 - Short-term Trading: A US pension fund registered as FPI purchases ₹5,00,00,000 in 364-day treasury bills and sells them after 6 months for ₹5,25,00,000. The short-term capital gain of ₹25,00,000 is exempt from taxation. Previously, this would have been taxed at 30% plus applicable surcharge and cess (effectively around 35-40% depending on DTAA provisions), resulting in a tax liability of approximately ₹8,75,000 to ₹10,00,000.

Foreign investors can use the Capital Gain Calculator to model different investment scenarios and compare post-tax returns under various holding periods and transaction structures.

Comparison: Pre-2026 vs. Post-2026 Tax Treatment

Parameter	Before April 1, 2026	After April 1, 2026
LTCG Tax Rate (>36 months)	10% without indexation or DTAA rate	0% (Completely Exempt)
STCG Tax Rate (<36 months)	30% + surcharge + cess or DTAA rate	0% (Completely Exempt)
Interest Income Taxation	20% + surcharge + cess or DTAA rate	20% + surcharge + cess or DTAA rate (No Change)
Withholding Tax on Capital Gains	Section 195 TDS applicable	No TDS on exempt capital gains
Minimum Documentation	PAN, TRC, Form 10F	PAN, TRC, Form 10F, SEBI/RBI registration
Eligible Securities	All debt instruments	Only G-Secs, SDLs, T-Bills (specified securities)

Strategic Implications for Foreign Portfolio Allocation

The elimination of capital gains tax fundamentally alters the risk-return calculus for foreign institutional investors evaluating Indian fixed-income allocations. Several strategic considerations emerge from this policy change.

Enhanced Returns and Competitive Positioning

With capital gains now tax-exempt, the effective yield on Indian government securities for foreign investors increases by 10-30% depending on the holding period and previous tax treatment. This makes Indian G-Secs significantly more competitive relative to sovereign debt from other emerging markets like Indonesia, Thailand, or Brazil, where foreign investors typically face capital gains taxation ranging from 10% to 25%.

Duration and Trading Strategy Optimization

Previously, the differential tax treatment between short-term and long-term capital gains incentivized longer holding periods to access lower LTCG rates. With both categories now exempt, foreign investors can optimize portfolio duration and implement active trading strategies based purely on interest rate views and macroeconomic forecasts without tax considerations distorting investment decisions.

Impact on Foreign Exchange Flows

Industry analysts estimate that this exemption could attract an additional $15-20 billion in foreign portfolio flows into Indian government securities over the next 24 months. This would expand the investor base, improve secondary market liquidity, and potentially reduce government borrowing costs by 15-25 basis points across the yield curve as demand from tax-exempt foreign investors increases.

Compliance Requirements and ITR Filing Obligations

Despite the exemption, foreign investors must continue to fulfill all income tax return filing obligations and maintain detailed records of government security transactions for potential scrutiny by tax authorities.

Income Tax Return Filing

FIIs and FPIs earning income in India must file income tax returns using Form ITR-2 (for individuals) or Form ITR-3 (for entities with business income). Even though capital gains are exempt under Section 10(4D), they must be reported in the appropriate schedules of the return to demonstrate compliance and claim the exemption benefit.

The exempt capital gains should be separately disclosed in Schedule EI (Exempt Income) of the return with specific reference to Section 10(4D) and details of each transaction including:

• ISIN (International Securities Identification Number) of the security
• Date of acquisition and transfer
• Purchase and sale consideration
• Computation of capital gains (which are then claimed as exempt)
• Custodian details and transaction references

Transfer Pricing and Documentation Requirements

For FIIs that are associated enterprises of Indian entities, transfer pricing provisions under Sections 92 to 92F of the Income Tax Act may apply to certain transactions. While government security purchases in the secondary market through recognized stock exchanges typically do not raise transfer pricing concerns, FIIs should maintain contemporaneous documentation to demonstrate arm's length nature of all transactions with related parties.

The Form 26AS / TDS Fetch Tool can help foreign investors verify TDS credits on interest income and ensure accurate reporting in their tax returns.

Recent Developments and CBDT Clarifications

Following the Finance Act 2026 amendments, the Central Board of Direct Taxes has issued several circulars and notifications to clarify implementation aspects of the capital gains exemption for foreign investors.

CBDT Circular 8/2026 - Operational Guidelines

Issued on May 15, 2026, CBDT Circular 8/2026 provides comprehensive operational guidelines addressing frequently asked questions from foreign investors and custodian banks. The circular clarifies that the exemption applies to both on-exchange and over-the-counter transactions in eligible government securities, provided the transactions are executed through SEBI-registered stockbrokers or primary dealers and properly reported to depositories.

Grandfathering Provisions for Existing Holdings

For government securities acquired by FIIs before April 1, 2026, a grandfathering mechanism allows investors to step up the cost of acquisition to the fair market value as of April 1, 2026. This ensures that capital appreciation accrued before the exemption date remains subject to taxation under the previous regime, while gains arising after April 1, 2026, benefit from the exemption.

The fair market value for this purpose is determined as the average of the highest and lowest traded price on recognized stock exchanges on April 1, 2026, or the immediately preceding trading day if April 1 was a non-trading day.

Interaction with Tax Treaties

The exemption under Section 10(4D) is a domestic law provision that operates independently of Double Taxation Avoidance Agreements. Foreign investors can claim this exemption regardless of whether their home country has a tax treaty with India. However, for interest income and other taxable components, DTAA provisions continue to apply, and investors should claim the more beneficial treatment between domestic law rates and treaty rates.

Risk Factors and Considerations

While the capital gains exemption offers substantial benefits, foreign investors should be aware of potential risk factors and compliance pitfalls that could affect their ability to claim the exemption.

Regulatory Status Maintenance

The exemption is available only to entities maintaining valid SEBI registration as FPIs throughout the period of holding and transfer of securities. Any lapse in registration, suspension by SEBI, or cancellation of FPI status would disqualify the investor from claiming exemption benefits, potentially resulting in retrospective tax liability on capital gains.

Substance Requirements

Tax authorities may examine whether foreign investment vehicles have adequate substance in their jurisdiction of incorporation or are established primarily for tax avoidance purposes. The General Anti-Avoidance Rule (GAAR) provisions under Section 96 to 102 of the Income Tax Act could potentially be invoked if arrangements lack commercial substance, though the specific application to sovereign debt investments remains subject to interpretational guidance.

Currency Risk and Hedging Treatment

While capital gains on the underlying government securities are exempt, foreign investors should note that forex gains or losses arising from currency fluctuations or hedging transactions are treated separately for tax purposes. Gains on foreign exchange derivative contracts used to hedge rupee exposure may be taxable as business income or capital gains depending on the nature and frequency of transactions.

Investors engaged in equity and debt investments can utilize the Stock Profit Calculator to model comprehensive returns including tax implications across different asset classes.

Procedural Roadmap for Claiming the Exemption

Foreign investors should follow a systematic approach to ensure compliance and successful claiming of capital gains tax exemption on government security investments.

Step 1: Verify Eligibility

Confirm that your entity holds valid SEBI registration as FPI (Category I, II, or III) and has obtained PAN from Indian tax authorities. Ensure that the securities being purchased fall within the eligible category of government securities as defined in Section 10(4D) and related notifications.

Step 2: Maintain Transaction Documentation

Work with your designated custodian to maintain comprehensive records of all government security transactions including contract notes, settlement confirmations, depository statements showing ISIN-wise holdings, and detailed capital gains computation worksheets for each financial year.

Step 3: File Income Tax Returns

File ITR-2 or ITR-3 before the due date (typically July 31 for non-audit cases), ensuring that exempt capital gains are properly disclosed in Schedule EI with reference to Section 10(4D). Attach detailed schedules showing security-wise transaction details and gains computation.

Step 4: Respond to Assessment Notices

If selected for scrutiny assessment, promptly provide all requested documentation to the Assessing Officer including SEBI registration certificates, custodian confirmations, TRC, Form 10F, and detailed explanation of the exemption claim with reference to applicable legal provisions.

The Bank Statement Analyser can help organize financial documentation for tax compliance and assessment proceedings.

Frequently Asked Questions

Which foreign investors are eligible for the capital gains tax exemption on G-Secs?

All registered Foreign Institutional Investors (FIIs) and Foreign Portfolio Investors (FPIs) investing in eligible government securities are covered under the exemption. This includes sovereign wealth funds, pension funds, endowment funds, and registered foreign asset management companies investing through the designated investment routes approved by RBI and SEBI. The exemption applies to both long-term and short-term capital gains on specified government securities purchased after April 1, 2026.

Does the exemption apply to state government securities or only central government bonds?

The capital gains tax exemption applies to both central government securities (G-Secs) and state development loans (SDLs) issued by state governments. However, corporate bonds, municipal bonds, and government-guaranteed bonds issued by PSUs do not qualify for this exemption. Only sovereign securities issued directly by the central or state governments and treasury bills with maturity periods as specified in the Finance Act 2026 notification are eligible for tax-free capital gains treatment.

How does this exemption impact withholding tax obligations for FIIs?

Under the new exemption regime, capital gains from eligible government securities are exempt from withholding tax (TDS) under Section 195 of the Income Tax Act. However, interest income from these securities remains taxable as per applicable Double Taxation Avoidance Agreement (DTAA) rates or domestic tax rates, whichever is lower. FIIs must still comply with TDS provisions on interest payments and obtain Tax Residency Certificates (TRC) to claim DTAA benefits on non-exempt income streams.

What documentation do FIIs need to claim the capital gains tax exemption?

FIIs must maintain comprehensive documentation including SEBI/RBI registration certificates, PAN cards, investment transaction records with timestamps, custodian statements showing G-Sec holdings, and Form 10F declarations establishing foreign tax residency. When filing returns, FIIs should report exempt capital gains separately in the ITR schedules and attach supporting schedules detailing security-wise transaction details, acquisition dates, sale dates, and capital gains computation for each eligible government security transaction during the financial year.

Can FIIs who already hold G-Secs benefit from this exemption retroactively?

The exemption applies prospectively to capital gains arising from government securities purchased on or after April 1, 2026. For G-Secs acquired before this date, capital gains will be subject to grandfathering provisions where cost of acquisition may be stepped up to fair market value as of April 1, 2026, for computing future gains. This ensures that appreciation accrued before the exemption date remains taxable under previous provisions, while post-April 1, 2026 gains qualify for the exemption treatment as per the transition mechanism specified.

Conclusion

The elimination of capital gains tax on FII investments in government securities represents a transformative policy reform that significantly enhances the attractiveness of Indian sovereign debt for global institutional investors. By removing tax friction on capital appreciation while maintaining India's position in global fixed-income indices, this measure is expected to deepen market liquidity, reduce borrowing costs, and strengthen India's integration with international capital markets. Foreign investors should work with qualified tax advisors to optimize their investment structures, ensure compliance with all documentation requirements, and fully leverage the benefits of this exemption regime. Explore TaxFetch Tools to calculate your tax liabilities, analyze investment returns, and streamline compliance across your Indian investment portfolio.