Foreign institutional investors (FIIs) have withdrawn $21 billion from Indian markets since the beginning of 2025, prompting equity strategists to look toward the Union Budget as a potential catalyst for reversing this trend. Morgan Stanley's Ridham Desai, who leads the firm's India equity strategy team, has identified three specific capital market reforms that could meaningfully address the FII outflow challenge.

Three Key Reform Areas

Desai outlined the potential reforms in a Budget strategy note, emphasizing their importance in addressing foreign portfolio investor concerns:

"There has been growing concern about the negative balance of payments and foreign portfolio investor (FPI) selling. In this context, it is quite possible that the Budget proposes broadening the base of foreign portfolio investors, allowing more pools of capital to access Indian stocks," Desai stated.

GIFT City Development Strategy

The enhancement of GIFT City represents a significant opportunity for India to compete with established international financial centers. As global financial flows increasingly route through such centers, GIFT City remains underdeveloped compared to peers like Singapore and Hong Kong. By strengthening tax incentives and regulatory frameworks, the government could attract more foreign capital into Indian securities through platforms such as the Gateway International Exchange.

This development would create additional avenues for FII participation, particularly benefiting investors facing regulatory or structural constraints in traditional market-access mechanisms.

Current Market Outflow Situation

The foreign investment landscape presents concerning trends for Indian markets:

Budget Expectations and Market Positioning

Desai's team expects the Budget to focus on several key areas that could support market recovery. "It appears the market is expecting modest fiscal consolidation to protect growth, flat to higher capital spending as a percentage of GDP, and some additional tax incentives for manufacturing," he noted.

The Budget is likely to emphasize deficit reduction, government capital expenditure, the debt calendar, and capital market reforms specifically aimed at boosting foreign inflows. Morgan Stanley maintains an overweight stance on Financials, Consumer Discretionary, and Industrials sectors, which would likely serve as primary beneficiaries if FII flows return.

Historical Budget Performance Analysis

Morgan Stanley's analysis reveals important patterns in market behavior around Budget announcements. India is currently tracking lower on both absolute and relative bases heading into the budget. Historical data shows that when equity markets have fallen in the 30 days preceding the Budget announcement, the probability of a post-budget rally increases meaningfully.

Conversely, the market has historically fallen on two of three occasions in the 30 days following the budget. This probability rises to 75% if the market has risen in the 30 days preceding the budget. Only on three occasions in 32 years has the market been up both before and after the budget, with the most recent occurrence in 2024.

"This year, India is tracking lower on both an absolute and relative basis, and if it were to hold this performance into the budget day, the chances of a post-budget rally increase," the global brokerage concluded.

Tax policy experts have presented comprehensive recommendations for Budget 2026 to enhance India's mergers and acquisitions environment, particularly with the Income-tax Act, 2025 scheduled for implementation from April 1, 2026. The suggestions aim to address existing regulatory gaps and improve the ease of doing business for M&A transactions.

Fast-Track Demerger Tax Neutrality

A primary recommendation involves extending tax neutrality to fast-track demergers under Section 233 of the Companies Act, 2013. Currently, the Income-tax Act, 2025 provides tax neutrality only to NCLT-approved demergers under Sections 230 to 232, excluding fast-track demergers that enable small or closely held companies to undertake demergers without court approval.

The finance ministry's rationale for excluding fast-track demergers centers on concerns about potential valuation manipulation without court oversight. However, experts argue this approach contradicts the ease of doing business agenda, forcing genuine taxpayers to choose between transaction efficiency and tax benefits.

Contingent Consideration Clarity

Experts emphasize the need for clear taxation guidelines on earn-out, profit-linked, or contingent consideration arrangements that have become increasingly common in M&A transactions. These arrangements tie part of the sale consideration to achieving specific profitability or financial milestones.

The current legal framework lacks clarity on:

• Taxability of contingent payments
• Timing of taxation for such arrangements
• Treatment of milestone-based considerations

Foreign Company Merger Anomalies

The recommendations address existing inconsistencies in foreign company merger taxation. While foreign companies enjoy capital gains tax exemptions on direct or indirect share transfers during mergers with other foreign companies, shareholders of the amalgamating company face potential capital gains liability on share swaps.

This creates an anomaly compared to domestic mergers, which provide exemptions at both company and shareholder levels.

Capital Gains Tax Rate Concerns

The recent capital gains tax regime rationalization introduced higher long-term capital gains tax rates, which experts suggest adversely impacts investor returns and exit efficiency. The increased rates potentially drive investors toward jurisdictions with more favorable tax regimes.

Key concerns include:

• Reduced post-tax returns for investors
• Decreased competitiveness with other investment destinations
• Impact on foreign capital attraction

Experts recommend reducing capital gains tax rates, suggesting restoration of the earlier 10.00% rate to improve India's competitive position in attracting foreign investment.

Strategic Implementation Timeline

With the Income-tax Act, 2025 set for April 1, 2026 implementation, Budget 2026 represents the final opportunity to incorporate these amendments before the new framework takes effect. The recommendations aim to position India as a preferred destination for cross-border M&A activities while maintaining regulatory integrity and supporting corporate growth objectives.