$64 billion out, $5 billion in? Why LTCG tax cut may not be enough to bring FIIs back

ETMarkets.com

Analysts at JM Financial estimate that scrapping LTCG for FIIs investors could add $3–5 billion to FY28 inflows in its bull case, compared with the roughly $64 billion they have pulled from Indian equities since October 2024. The brokerage says the tax relief could lift an average foreign investor’s annual dollar return by 2.2 percentage points but cautions that it is a “second-order lever” alongside valuations and oil prices.

“Tax efficiency alone will not bring foreign capital back to India,” said Nirav Karkera, Head of Research and Funds Manager at W by Groww. “Ultimately, tax reform can remove a reason for investors to stay away, but it cannot create a reason to invest. That conviction will have to come from earnings delivery, reasonable valuations and confidence in the rupee.”

Earlier in the month, The Economic Times reported that the government has sought the views of investors, market functionaries and tax experts on LTCG and securities transaction tax (STT) as it begins a reassessment of capital market levies amid an exodus by overseas investors. On Monday, Reuters reported that Sebi has recommended removing LTCG on foreign investors. The recommendations are not binding, and the final decision rests with the government ahead of the February Budget.

India’s current tax regime imposes a 20% short term capital gains tax (STCG) and a 12.5% LTCG on listed equities, apart from STT.

For foreign investors, the tax is calculated on rupee gains rather than dollar gains. That means an investor can owe tax even when the gain is much smaller in dollar terms or when currency depreciation has left the investor with a dollar loss.

JM Financial estimates that removing LTCG would improve an average foreign investor’s annual dollar return by about 2.2 percentage points. A one-point expansion in the Nifty’s price-to-earnings multiple would be worth about 5.8%, according to the report. A return from the current 17.1 times forward earnings to the 10-year average of 21.3 times would imply a 24.3% valuation gain.

In other words, tax relief could make India more attractive at the margin. It may not be powerful enough to make investors overlook oil prices, currency risks or competing emerging markets.

Also Read |Sebi backs removal of LTCG tax for foreign investors: Report

Why oil remains the bigger trigger

The report’s analysis of two decades of monthly data suggests that crude oil, rather than economic growth or taxation, is the more immediate trigger for foreign flows.

Brent crude above about $105 a barrel has historically been associated with FII selling, while prices below about $90 have marked a zone where flows turn neutral to positive.

Since 2016, in the months when Brent averaged above $105, FIIs sold in six out of seven months, with average outflows of $4.1 billion. Below $75, average monthly flows were positive at between $700 million and $900 million.

India can reduce the tax burden on foreign investors, but it cannot use tax policy to neutralise the impact of an elevated oil bill, pressure on the current account or the resulting concerns over the rupee. Analysts say India needs lower oil prices followed by three consecutive months of confirmed inflows before investors can treat the FII cycle as having turned.

Indian equities have already become cheaper after the prolonged selloff. The Nifty’s forward price-to-earnings multiple has fallen to 17.1 times, corresponding to an earnings yield of 5.8%.

Historically, that valuation zone has been supportive for future flows. Markets starting at 15–18 times earnings recorded average FII inflows of $14.1 billion over the following 12 months.

But valuation did not prevent heavy selling during the latest shocks. In March 2026, when the Nifty traded at 18.4 times forward earnings, the valuation model implied $3.8 billion of inflows over the following six months. Instead, FIIs sold $12.7 billion.

India’s tax gap with Asian peers

India is an outlier among major Asian markets in taxing foreign investors on listed equity gains. Korea, Taiwan, Singapore, Hong Kong and China generally offer more favourable treatment to FIIs, although their transaction tax regimes differ.

The tax burden also creates what JM Financial calls “phantom gains”, periods when foreign investors make money in rupee terms but lose money in dollars. Such instances occurred in 28 of the 201 months analysed, or about 14% of the sample.

That is why targeted reforms may be more efficient than a blanket abolition. The report lists alternatives including taxing foreign investors on dollar gains, indexing the cost base for rupee depreciation, reducing the gap between short- and long-term tax rates, or shortening the 12-month holding period for FPIs.

Such measures could address currency-related distortion while limiting the fiscal cost.

Any broad tax cut would come with a significant fiscal cost. Equity LTCG collections stood at about ₹1.29 lakh crore in FY25, according to the reports. Jefferies estimates that LTCG on equities and STT together accounted for 8% of direct tax collections and 5% of total gross tax revenue in FY25.

The share attributable specifically to foreign portfolio investors is not disclosed, making the cost of FPI-only relief difficult to estimate.

That leaves the government with a policy balancing act: provide enough relief to improve India’s competitiveness and foreign-investor sentiment, without creating a large revenue hole.

Finance Minister Nirmala Sitharaman said recently that LTCG was “something a lot of people are commenting on, both Indian and foreign investors.” She also described the debate over STT and taxation across asset classes as “healthy.”

Where would FIIs return first?

If the tax proposal is accepted and global conditions improve, the first beneficiaries are likely to be large-cap and FII-heavy sectors rather than the broader market.

Since October 2024, financial stocks have seen the largest foreign outflows at $16 billion, followed by IT at $10 billion, consumer staples at $10 billion, oil and gas at $8.4 billion and autos at $8.1 billion.

Jefferies favours financials, energy, utilities and real estate among sectors that could benefit from a reversal in foreign flows. It also prefers large-caps over mid-caps, noting that large-caps trade at a 23% discount to their 10-year average valuation.

JM Financial’s base case sees $10–15 billion of FII inflows in FY28 if Brent remains between $100 and $115 before easing. In a more favourable de-escalation scenario, flows could rise to $20–25 billion. Under an escalation scenario, FY28 could still see outflows of about $10 billion.