India’s plans to crack down on tax avoidance by online vendors could raise costs for foreign e-commerce sites as they compete to tap into the country’s multibillion dollar marketplace.

One of the government’s proposals, outlined in a Feb. 23 draft policy, would require all foreign e-commerce sites, such as Alibaba Group Holding Ltd., to register as business entities in India, making them responsible for compliance and collecting taxes. Vendors on those sites would no longer be able to label their products as “gifts”—a widely abused loophole to avoid paying tax.

Agencies would have more power to track e-commerce...