Angel Tax on Indian Startups

Angel tax is what Indian start-ups are really worried about now. Remember, this angel tax was first introduced in the year 2012. The logic of then finance minister, Dr. Pranab Mukherjee, was quite simple. The concept of a private closely-held company cannot be misused to generate unaccounted money through fancy valuations assigned to undeserving companies. The problem is that valuations are based on judgement and cannot be on financial parameters alone.

However, the challenge of the government was to ensure that such slush money transactions are discouraged, without discouraging the robustness of the start-up ecosystem. That is a tough call and had been an untouched area for some time. However, Finance Bill 2023 has added a new dimension by bringing select global investors from select jurisdictions under the umbrella of angel tax. The million dollar question is whether it would deter the start-up ecosystem or whether there is just a lot of fear mongering sloshing around in the market.

What the Finance Bill 2023 actually says on angel tax

As per the fine print of the Finance Bill 2023, investors from 21 countries including the US, UK, France, Australia, Japan and others have been exempted from angel tax for investments in unlisted Indian startups. The CBDT is fairly confident of the extent of compliance and checks and balances in these countries. However, other countries like Singapore, the Netherlands and Mauritius are not included in this exempt-list. That means, investments coming from these countries will be subject to angel tax if the FMV condition is not satisfied. Ironically, these 3 countries account for a major chunk of foreign direct investment (FDI) flows into India. That is why the concern that the flow of FDI into India could be hit by the imposition of angel tax.

Understanding the angel tax exemption list

Let us understand how angel tax works at the current juncture. Currently, resident investors putting money into unlisted start-ups continue to be governed by the provisions of the angel tax. VCs continue to be outside t, he purview of angel tax imposition and this has now been extended to the Venture Capital firms located in the IFSC (International Financial Services Centre) also. Some of investor entities exempted from the purview of angel tax by the CBDT include Sebi registered Category-I FPIs, Endowment Funds, Pension Funds and pooled investment vehicles with more than 50 investors. In addition, any resident of the 21 jurisdictions like the US, UK, Australia, Japan, France, and Germany will also be exempt. Austria, Canada, Israel, Italy, Korea, Russia, New Zealand and Scandinavia are exempt too.

Apart from the above, other government entities have also been exempted from the purview of angel tax. These include investors like the central banks, sovereign wealth funds, international or multilateral organisations like World Bank / IMF, and entities that are substantially under the control of the government. In all these cases, the provisions of the new angel tax and FMV will not be applicable.

Why are start-ups a worried lot now?

Ironically, a bulk of the start-up funding into India gets routed through jurisdictions like Mauritius, Singapore, and Netherlands. By not exempting flows from these nations, start-ups are worried that it could seriously hamper their fund raising plans, especially at a time when the start-up funding ecosystem is just about starting to look up all over again. Currently, Singapore, Mauritius and UAE provide half of FDI flows into India and that is likely to get impacted. Ironically, these countries are not in the exempted list so they are vulnerable to being hounded by the tax authorities over angel tax issues.

Experts are of the view that eligible start-ups are still a miniscule 2% of the total number of start-ups in India. Even legal experts feel that this would not only discourage FDI into India from these jurisdictions but once again encourage reverse flipping of ownership and domicile structures. Start-ups may prefer going and domiciling companies in jurisdictions like UAE or Singapore, which are willing to roll out the red carpet anyways. The intent of the government is to attract more funds from countries that have robust regulatory frameworks. However, that sounds very good on paper, but could be largely impractical.

Recapping the gist of the angel tax provisions

So, angel tax is certainly a concern for start-ups. They legitimately apprehend that global investors may not be too keen to invest in India start-ups if they have to go through the more stringent regulatory framework of countries like the US, UK and Western Europe. Most experts are of the view that this problem is actually quite small and putting all start-up funding at risk may be a lot more like throwing out the baby with the bathwater.

Let us quickly recap the angel tax provisions for a final word on the subject. The provisions enshrined in the Angel Tax rules states that when an unlisted company, such as a start-up, receives equity investment from a resident for issue of shares that exceeds the fair market value (FMV) of such shares, it would be treated as income in the hands of the start-up and would be taxed as Income from Other Sources.

Finance Bill 2023, extends this existing provision to non-resident investors also. Only flows from the 21 countries will be free of angel tax while the other FDI sources would be subjected to scrutiny. The government may have tried to plug the loophole and prevent money laundering. However, the practical difficulties in getting such a move implemented are just too many. It is not the intent but the implementation that is the real road block; and what can serve to unnecessarily disrupt the momentum of start-up investing in India. In the last 10 years, India has produced more than 100 unicorns and has become the third largest start-up ecosystem in the world after the US and China. These advantages cannot and must not be frittered away. That is what start-ups are demanding.