India cut tax rates for foreign investors on interest income from investments in government and corporate debt, hoping to attract more funding to bridge its current account deficit and polish its reformist credentials.

The change in withholding tax, which a senior finance ministry official said would fall to 5 percent from 20 percent, delivered on a promise to foreign investors by Finance Minister P Chidambaram during a recent visit to North America.

The cut, welcomed by markets and part of a finance bill passed on Tuesday by the Lok Sabha amid an opposition boycott, would be effective for two years from June 1, the minister said.

Chidambaram has been a strong advocate within the government of fiscal reforms to attract increased levels of foreign investment, though many other Asian countries including Singapore do not tax such interest income at all.

The government relaxed ownership limits for the foreign investment community at the start of April, allowing it to hold up to $25 billion in government bonds and $51 billion in corporate bonds at any one time.

Foreigners have invested more than $11 billion in Indian equities and nearly $3 billion in debt so far this year.

"The cut in the tax rate for foreign investors should help Indian companies to raise more funds," said Pranav Sayta, tax partner at tax consultancy Ernst and Young.

Another finance ministry official said the government would soon ease rules on Indian shipping, telecom and real estate companies raising funds in overseas markets.

Chidambaram said a tax residency certificate issued by a foreign government would be an accepted proof of residency for foreign investors to avoid being taxed both in India and their home country.

In its budget proposals, the government had said that would be "(a) necessary but not a sufficient condition".

Hopes that Tuesday's reforms would increase capital inflows boosted Indian markets. The 10-year benchmark government bond yield fell as much as 3 basis points to 7.73 percent while the rupee closed up 0.8 percent against the dollar at 53.80.

"The regulators are gradually liberalising the debt markets," said Rohit Arora, emerging market rate strategist at Barclays Capital.

"Our estimate of $6-8 billion capital inflow in government bonds in 2013/14 fiscal year is at a upside risk following these measures."

Adverse investment flows have contributed to widening India's current account deficit, which reached 6.7 percent of economic output in December quarter - mainly driven by crude oil and gold imports - and is the government's biggest economic headache.

(Reporting by Manoj Kumar & Rajesh Singh; Writing by Subhadip Sircar; Additional reporting by Suvasree DeyChowdhury; Editing by Kim Coghill, John Stonestreet)