SEBI Recommends Abolishing 12.5% Long-Term Capital Gains Tax for Foreign Investors
In a major pre-budget submission aimed at reviving overseas institutional participation in Indian equities, the Securities and Exchange Board of India (SEBI) has recommended that the central government scrap the long-term capital gains (LTCG) tax imposed on foreign portfolio investors (FPIs). Alongside relief for foreign institutions, the markets watchdog has also proposed tax exemptions for domestic mutual fund investors when switching or reinvesting proceeds from existing holdings into new schemes.
The proposals, submitted ahead of the annual Union Budget scheduled for February, are non-binding and place the final decision squarely with the Ministry of Finance.
Halting Massive Foreign Outflows
The regulator’s proposal comes amid sustained, historic sell-offs by overseas institutional investors. FPIs have pulled over $31 billion (exceeding ₹3 lakh crore) from Indian equities this year, pressuring benchmark indices and creating persistent downward volatility for the Indian rupee.
Foreign investors have consistently raised objections to India's high cumulative transaction costs. Over the past two years, regulatory consultations highlighted taxation as a primary friction point deterring long-term capital allocation. At present, investors face:
- A 12.5% LTCG tax on listed equities held for more than 12 months.
- A 20% short-term capital gains (STCG) tax on holdings sold within a year.
- Securities Transaction Tax (STT) applied to both purchase and sale legs of cash and derivatives transactions.
- Dividend withholding taxes, alongside foreign exchange risks.
Brokerages including Jefferies and IIFL estimate that completely eliminating capital gains taxes for foreign portfolio investors could raise net foreign investor returns by approximately 2.3 percentage points, potentially tipping the scales back in favour of Indian asset allocations.
Parallel Relief for Domestic Mutual Fund Investors
To ensure fairness and encourage continuous domestic participation, SEBI has simultaneously mooted a key concession for retail and domestic mutual fund unitholders. Under current tax regulations, redeeming units in one equity mutual fund to invest in another triggers an LTCG tax liability if aggregate annual capital gains exceed ₹1.25 lakh.
SEBI has recommended granting an LTCG tax exemption on switches where the redemption proceeds are directly rolled over and reinvested into mutual fund schemes. If implemented, this measure would remove an unnecessary tax drag for retail investors rebalancing portfolios across different asset classes or themes.
Market Impact and Fiscal Considerations
While foreign investors and domestic market participants have long lobbied for simpler taxation, the Ministry of Finance faces a difficult balancing act. Surrendering LTCG collections would impact direct tax revenue, and policymakers have previously voiced concerns over maintaining tax parity between domestic residents and non-resident foreign investors while preventing the round-tripping of capital.
Nevertheless, with India competing against alternative emerging markets such as South Korea and Taiwan—which offer lower effective capital gains tax burdens—market participants view SEBI's formal recommendation as a crucial catalyst that could redefine institutional inflows in the upcoming fiscal year.
