The debate over India's capital gains tax regime has gained momentum after the Securities and Exchange Board of India (Sebi) reportedly backed scrapping long-term capital gains (LTCG) tax on equity investments by foreign portfolio investors (FPIs).The proposals have gained attention amid growing calls for a review of India's capital gains tax structure. Finance Minister Nirmala Sitharaman has acknowledged the concerns raised by market participants and said the government would review them.

However, she has not committed to scrapping the tax.With foreign investors pulling out billions of dollars from Indian equities this year, the proposal has raised an important question: could removing the tax help bring them back, or are the reasons behind the selling much bigger?Market experts believe that doing away with LTCG tax could make Indian equities more competitive and improve post-tax returns for foreign investors. However, they caution that taxation is only one part of an investment decision.

Earnings growth, valuations, currency movements, crude oil prices and global interest rates continue to play a much bigger role in determining where foreign funds are invested. Rajesh Singla, CEO and Fund Manager at Alpha AMC, said taxation adds to the cost of investing in India, but it is not the primary reason behind foreign investors selling domestic equities."Tax is a cost for foreign funds, not the reason they are selling," he said.

Under the current regime, foreign portfolio investors pay 12.5% tax on long-term capital gains and 20% on short-term capital gains. Securities transaction tax (STT) of 0.10% also applies on both the purchase and sale of shares, with surcharge and cess adding to the overall tax burden.Singla said this can affect long-only funds and exchange-traded fund (ETF) investors, particularly when they compare India with markets such as Taiwan, Hong Kong and Singapore, where gains from listed equities are not taxed."If the government accepts the proposal, it would sharpen India's pitch at the margin.

But a fund first asks whether it can make money in dollars, and only then what it keeps after tax," he said.WHY SEBI WANTS LTCG TAX SCRAPPEDSebi's recommendation comes at a time when foreign investors have been withdrawing substantial amounts from Indian equities. The regulator has reportedly suggested removing LTCG tax on equity investments made by foreign portfolio investors as part of its pre-Budget recommendations to the government.It has also proposed tax relief for domestic mutual fund investors switching from one scheme to another, provided they have held the units for more than a year.

Under the proposal, such switches would not be treated as taxable sales, allowing investors to rebalance their portfolios without immediately triggering an LTCG liability.These recommendations are not binding, and the final decision rests with the government.HOW MUCH DIFFERENCE CAN SCRAPPING LTCG MAKE?Removing LTCG tax could improve the returns foreign investors take home from Indian equities. This may make India more competitive against other emerging markets, particularly for funds that compare investment destinations on the basis of post-tax returns.Singla cited an estimate by IIFL, which suggests that scrapping capital gains tax could add around 2.3 percentage points to foreign investors' returns.However, he cautioned that the benefit may not automatically translate into fresh inflows.

Foreign investors assess their returns in dollar terms, and currency depreciation can offset some of the gains made in the domestic market."In practice I would expect more signal than flow. India taxes the gain in rupees, so a currency near record lows can take back much of that benefit in dollar terms," he said.Singla also pointed to the experience of other Asian markets.

He said JM Financial had noted that foreign investors were buying stocks in South Korea and Taiwan during the same months in which they were selling Indian equities. This suggests that the decision to reduce exposure to India is not simply about taxation, but also about the relative attractiveness of other markets.WHAT IS REALLY DRIVING FII OUTFLOWS?Foreign investors consider several factors before allocating money to an emerging market.

Even if India removes LTCG tax, global interest rates, currency stability, crude oil prices and corporate earnings could continue to influence their investment decisions.Singla identified four factors that need to turn favourable before foreign investors return in a sustained manner.The first is US bond yields. He said the US 10-year Treasury yield was near 5.3%, allowing investors to earn relatively attractive returns without taking on the additional risks associated with emerging markets.The second is the rupee.

According to Singla, the currency had been hovering near record lows of around Rs 96 against the dollar, reducing the dollar-denominated returns earned by foreign investors.The third factor is crude oil. Higher oil prices can increase India's import bill and add to inflationary pressures, making the domestic economic and market outlook less attractive.The fourth is corporate earnings.

Foreign investors need to see companies deliver earnings growth that justifies their valuations and offers the potential for better returns.Singla said Indian market valuations had already corrected to around 20.5 times trailing earnings, but foreign investors continued selling. This suggests that lower valuations alone have not been enough to change their investment decisions.There are, however, some early signs of a change in flows.

Singla said foreign investors put around Rs 6,300 crore into Indian equities in the last week of October, after withdrawing Rs 34,843 crore during the month."One good week does not make a trend, and earnings upgrades will decide whether it lasts," he said.TAX REFORM CAN REMOVE A BARRIER, NOT CREATE INVESTMENT DEMANDNirav Karkera, Head of Research and Fund Manager at W by Groww, said Sebi's proposal was a step in the right direction, but tax efficiency alone would not be enough to bring foreign capital back to India.He said lower capital gains taxes could improve post-tax returns, reduce friction and make Indian equities more competitive against other emerging markets.Karkera also raised the issue of how foreign investors are taxed on their gains. He argued that FPIs should ideally be taxed on their actual economic gains rather than rupee appreciation that may disappear when returns are converted into dollars.However, he said the bigger drivers of foreign flows remain earnings growth, valuations, currency stability and India's relative attractiveness compared with other emerging markets."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," Karkera said.He also welcomed Sebi's proposal to make switches between domestic mutual fund schemes tax-neutral, saying it could improve capital allocation by allowing investors to rebalance their portfolios without an immediate tax penalty.CAN REASONABLE VALUATIONS AND TAX RELIEF STOP THE OUTFLOWS?Not all experts are cautious about the potential impact of the proposal.Mehul Koradia, Chief Strategy Officer at Mirae Asset Sharekhan, believes scrapping LTCG tax could make Indian markets more appealing to foreign investors, particularly at a time when valuations have become more reasonable.He said removing the tax would reduce the cost of investing for foreign investors and could help arrest the outflow of funds from Indian equities."With Indian markets at reasonable valuation, scrapping LTCG for foreign investors can stop the outflow of funds by foreign investor and can bring more foreign investment in India," Koradia said.He also described the proposal to remove LTCG tax when investors switch from one mutual fund scheme to another as a welcome move for retail investors.However, the potential benefit of tax relief has to be weighed against the government's revenue considerations. Singla cited Jefferies' estimate that equity LTCG collections stood at Rs 1.3 lakh crore in FY25, underlining the fiscal implications of any decision to remove the tax.The proposal has brought the capital gains tax debate back into focus, but investors should not assume that scrapping LTCG tax will automatically trigger a sustained return of foreign money.A tax cut could improve India's relative appeal and remove one of the costs associated with investing in domestic equities.

But foreign investors will also want to see a stable rupee, competitive returns compared with other markets, reasonable valuations and consistent corporate earnings growth.- Ends