Government considers Cut in Withholding Tax
Why in News?
The Government of India and the Reserve Bank of India (RBI) are considering reducing or even eliminating the withholding tax (WHT) on interest income earned by foreign investors on Indian government bonds.
The move is aimed at attracting foreign capital inflows, stabilising the rupee, and strengthening India’s external sector amid rising global uncertainty and capital outflows.
| UPSC Relevance: GS-3 Economy: External sector management; Capital markets and bond markets Prelims: Withholding Tax, Foreign Portfolio Investment (FPI), Forex Reserves |
What is Withholding Tax?
- Withholding tax is a tax deducted at source on payments made to non-residents. In the present context, it refers to the tax imposed on interest income earned by foreign investors from Indian government bonds. It functions similarly to Tax Deducted at Source (TDS).
- Example: If a foreign investor earns ₹100 as interest on Indian government securities and the withholding tax rate is 20%, ₹20 is deducted before payment.
Present Tax Structure in India:
- Earlier, foreign investors enjoyed a concessional withholding tax rate of 5% on certain rupee-denominated bonds. The concessional regime ended in 2023.
- Currently, most non-resident investors effectively pay around 20% withholding tax on interest income from Indian government bonds. This is one of the highest in the world.
Why is India considering a Reduction?
- To attract Foreign Capital Inflows: Foreign Portfolio Investors (FPIs) have withdrawn large amounts from Indian markets in recent months. Lower taxes can improve post-tax returns and make Indian bonds more attractive globally.
- To stabilise the Rupee: The rupee has weakened significantly against the US dollar due to higher US interest rates, rising crude oil prices, geopolitical tensions in West Asia and foreign capital outflows. The RBI’s capacity to continuously defend the rupee through forex intervention is limited.
- To protect Foreign Exchange Reserves: India’s forex reserves have come under pressure because of RBI intervention in currency markets, Oil import payments and Capital outflows. Greater foreign investment in bonds can increase dollar inflows and support reserves.
- To deepen India’s Bond Market: India has been integrating with global bond markets. Indian government bonds have recently been included in major global indices. Such inclusion can attract passive global investment flows.
Concerns regarding Reduction in Withholding Tax:
- Uncertain impact on Investment Flows: Policymakers fear that tax cuts alone may not attract substantial foreign investment because the US interest rates remain high, global uncertainty persists, and investors are risk-averse. Thus, the revenue sacrifice may not yield proportionate benefits.
- Revenue Loss to Government: Reducing withholding tax lowers tax collections from foreign investors. This could affect fiscal revenues.
- Vulnerability to Volatile Capital: Excessive reliance on foreign portfolio flows can expose the economy to sudden reversals. FPIs are often called “hot money” because they can exit quickly during crises.
- External Sector Risks Continue: Even if inflows rise temporarily, structural challenges remain high crude oil imports, global geopolitical instability and exchange rate pressures.
India should adopt a balanced strategy involving rationalisation of withholding taxes, deepening domestic bond markets, prudent forex reserve management, strengthening macroeconomic fundamentals and increasing stable long-term FDI inflows.
Practice MCQ:
Q. With reference to withholding tax in India, consider the following statements:
1. It is a tax deducted at source on payments made to non-residents.
2. Foreign investors pay withholding tax on interest income earned from Indian government bonds.
3. India currently has one of the lowest withholding tax rates in Asia.
Which of the statements given above are correct?
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3
Answer: (a)