UPDATE 1-India won't cut withholding tax on govt bonds-official

(Adds details, background, quotes)

By Arup Roychoudhury

NEW DELHI, July 5 (Reuters) - The Indian government has no plan to reduce withholding tax applicable for foreign investors buying government bonds as demand for these bonds are strong, a senior finance ministry official said on Thursday.

Bond dealers have been expecting the government to reduce such taxes to boost foreign fund inflows into India.

Some sell-off took place in government bonds after the official's comments. The second-most traded bond, 8.79 percent 2021, had gone up marginally to 8.3416 percent from 8.3267 percent before the news.

"Withholding tax is one of the key reasons why the FII (foreign institutional investor) auction is not getting good response," a trader with a foreign bank said.

"I have to pay a withholding tax for the full six months even if I buy a bond with a half-yearly coupon in August," the trader added.

India's debt limit auction on Wednesday met tepid investor response due to investment restrictions in the auctioned limits and because of thin participation by some investors on account of a U.S. holiday.

However, the government will reduce withholding tax from 20 percent to 5 percent on foreign investment in long-term infrastructure bonds and on external commercial borrowings in certain sectors like power, airline, roadways among others, the official said.

"We will not do this (reduce withholding tax) with government bonds as there is already enough demand for that. If there is demand for my products I will in fact raise prices," said the official, who declined to be identified as he was not authorised to speak to the media.

Pranab Mukherjee, the then finance minister, had proposed a cut in withholding tax on external commercial borrowings (ECB) in certain infrastructure sectors in his 2012/13 budget.

Foreign investors pay withholding tax of as much as 20 percent, depending on the tax treaty India holds with the corresponding country. A similar tax is applicable in many countries, including Indonesia and South Korea.

Withholding tax is a tax levied on incomes such as interests and dividends from securities owned by non-residents. (Writing by Suvashree Dey Choudhury; Editing by Jijo Jacob)