Amid the ongoing funding winter, start-ups have been thrown another curveball in the Budget 2023-24, which has proposed to extend “angel tax” to non-resident investors. This, experts believe, would deal a debilitating blow to overseas investment in India.
Padmaja Ruparel, co-founder of Indian Angel Network (IAN), India’s largest network of angel investors, considers the move as “taking two steps backward”, saying it will kill the industry of angel investing by non-resident investors. “The government needs to re-look at the move,” she said.
The Finance Bill has proposed an amendment to Section 56(2)(viib) of the Income Tax Act, which relates to angel tax, to include non-resident investors. They include investors, such as Sequoia Capital India, SoftBank, Tiger Global, and several high-net-worth individuals who invest via angel network groups.
Under the existing provisions, angel tax is levied on unlisted start-ups raising capital via the issue of shares “from any person being a resident”, if the share price of issued shares exceeds the fair market value (FMV) of the company.
“It is proposed to omit the words ‘being a resident’ from the said clause (viib) so as to cover all the investors within the ambit of the said clause of sub-section (2) of Section 56, irrespective of their residency,” read the Bill.
“It is a step back for start-ups looking to raise money from overseas investors,” said Ruparel. “This means that when overseas investors are investing in a start-up at a certain valuation, under Section 56(2)(viib), it is giving the income tax officer the right to question the valuation.”
“Having said that, if the income tax officer thinks that a firm is very highly valued, they will then convert the balance amount into income. This means that capital invested into a start-up will now be converted into income, and therefore, subject to income tax. This will, in turn, hinder overseas investors to invest in Indian start-ups,” she added.
Vaibhav Gupta, partner, Dhruva Advisors, believes the move would lead to heightened scrutiny of valuations at which the funds are raised. “The change on angel tax provisions being extended to non-residents could have significant consequences on fundraise structures from offshore funds and foreign companies. FEMA (Foreign Exchange Management Act) provisions permit Indian companies to issue shares to non-residents at above the fair market value. Now any such excess will be taxable in the hands of the company. Such onerous deeming income provisions will impact genuine FDI transactions in the country. Since the funds raised from AIFs are exempt, there may also be increase in investments from non-residents through AIFs,” he explained.
Vijay Sambamurthi, founder and managing partner of law firm Lexygen, said while the Budget has sought to remove discrimination between residents and non-residents in the applicability of the “angel” tax, start-ups that do not meet the conditions for claiming an exemption will now be subjected to this tax on capital raised from non-resident investors, as well.
“The new Finance Bill has also not proposed any exemption for foreign funds in the same vein as the current exemption for funds raised from domestic venture capital funds registered with Sebi,” said Sambamurthi. “This is a critical change that could potentially gravely affect the ability of several Indian start-ups to raise capital.”
Besides the angel tax predicament, Yagnesh Sanjharka, co-founder and CFO of 100X.VC, is of the view that other pertinent issues left unaddressed by the Budget may prolong the funding winter.
“Some key issues that didn’t get attention are no change to GST rates for registered start-ups, ESOP taxation, tax parity in base rates for unlisted shares, and tax benefits for angel investors taking up high-risk investing. This may adversely affect start-ups’ growth,” he said.
Industry watchers believe that early-stage start-ups would be the worst hit, as the segment witnesses comparatively higher deviation in allotted share prices and fair market value.
According to a recent report by PwC, start-up funding in the country fell 33 per cent YoY in CY22 to $23.6 billion, from $35.2 billion in the previous year due to a dearth of large funding rounds. Large foreign VC firms, such as SoftBank, Sequoia, Tiger Global, and Accel, have also reduced their investments in India.
Given the lack of large deals, early-stage funding saw a 12 per cent increase in CY22, compared to CY21, which accounted for 60-62 per cent of total funding in terms of volume. Global headwinds have pushed large foreign investors to focus more on early and seed-stage rounds, as well.
Experts are, therefore, wary of bringing overseas investors under angel tax purview as it may hinder foreign investment in India.
Some, however, believe the move may not have a big impact on the investment ecosystem.
“I do not see a significant practical impact on the ecosystem. Foreign investors are already taxed under the FEMA where they cannot buy stocks in unlisted Indian companies below their FMV. Similarly, they are not allowed to sell shares of unlisted companies at a price higher than their FMV. This is more of an enabling provision to plug potential loopholes,” said Vinay Bansal, co-founder and CEO of Inflection Point Ventures.