Foreign funding in local startups now subject to ‘angel tax’

Credit: Indian startups raising capital from foreign investors such as Sequoia Capital, Softbank, Prosus, Tiger Global, Carlyle, KKR and Blackstone, will now have to pay ‘angel tax’, a move that may not only adversely impact funding but also prompt more startups to locate overseas. While announcing the Union Budget on Tuesday, the finance minister said non-residents will now come under the purview of Section 56(2) VII B, better known as ‘angel tax’, which was introduced in 2012 as an anti-abuse measure that was aimed at tax-avoidance. Alternative investment funds registered with India’s market regulator Securities and Exchange Board of India (Sebi), however, continue to be exempted from angel tax. This is likely to be challenging for startups that are already reeling under a global funding crunch, as the bulk of the capital raised them is from foreign investors. In 2022, private equity and venture capital funding into India amounted to $54 billion, while it was close to $77 billion in 2021, a record year for Indian firms. “Non-resident investors were never under the scope of this tax,” Ritesh Kumar, Partner, J Sagar & Associates, said. “We are all hoping that this is a mistake,” he added. Angel tax is applied if the share price that is allotted to investors is at a premium to the fair market value (FMV) of the share. In this case, the difference is subjected to section 56 (2) VII B. For instance, if the fair market value (of a Re 1 face value share) is Rs 10 a piece, and if the startup allots a share at a premium of Rs 15, then the difference of Rs 5 would be taxed as income at the hand of the startup. Theoretically, this is likely to be more severe in the case of early to growth stage startups – where the divergence is higher between FMV and the price of the share allotted. This divergence is usually less stark in mature-companies. “So far, startups raising foreign capital were outside the purview of taxes as long as shares were issued in compliance with the Reserve Bank of India’s pricing guidelines on share premium. This proposes to bring into the tax net any amount received by a closely-held company (including start-ups unless they qualify as a venture capital undertaking receiving investment from venture capital fund) from a non-resident towards subscription of shares where the consideration is higher than the fair market value,” Kumar explained. This could compel more startups to flip overseas, as foreign investors may not want to deal with additional tax liability by virtue of their investment in the startup, according to Siddarth Pai, cofounder of VC firm 3one4 Capital. “The re-introduction is completely counterintuitive to the entire move of reverse-flipping. This, in fact, will accelerate flipping abroad,” Pai added. “Angel tax has been the sword of Damocles hanging over the heads of various Indian startups. This had been misapplied to them because all startups end up raising money from investors at a premium and often tax demand would come after one or one-and-a-half years. No investor would touch these startups because any money they put into the startup would actually go toward clearing the older tax liability,” Pai said. He added that this would be taxed for startups under “income from other sources” and corporate tax rate would apply. This would also apply to domestic investors who are not Sebi-registered AIFs. “If money came in from hypothetically a State Bank of India or LIC into a startup, that would also be liable to tax because they’re not Sebi-registered AIFs,” Pai added. To avoid the purview of angel tax, startups can file a “Form 2 Exemption”. However, according to the law, this exemption would prevent the startup from several activities such as not setting up a subsidiary, and not making any advances of salary, rental deposits, or vendor advances. Startups also can’t make treasury investments or participate in stock M&A – claiming the exemption would hamper the startup in many ways, according to Pai.Get daily update with our newsletter Subscribe Now !

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