Angel Tax: Return of The Devil

The newly proposed “Angel Tax” in the Finance Bill 2023 is anticipated to have an impact on all stages and sectors of Indian start-ups as well as having a significant influence on those who invest in angel investors

By Shivanand Pandit
  • During the continuing critical funding weakening, the suggested extension of the Angel Tax can further decelerate investments
  • To stop laundering of black money and round-tripping through investments with a huge premium into unlisted corporate entities, this clause was included
  • The angel tax appears somewhat faulty because it does not account for business needs and new financing techniques especially in the VC and PE galaxy
  • 20 out of the 108 unicorns in India are registered overseas, and therefore, the value and Intellectual Property generated by Indian start-ups are locked up

WHILE in 2019, start-ups respired a sigh of relief after the exemption from Angel Tax, the feared levy on capital receipts is now back in 2023. Proposed modifications of the Finance Bill 2023 will erase the exemption for foreign funds and non-resident investors who will have to pay a tax on the difference between capital raised and the fair value of securities disposed of.

During the continuing critical funding weakening, the suggested extension of the Angel Tax can further decelerate investments or even compel start-ups to flip outside India. Maybe it’s time to term it by a novel name because the new recommended realm of the so-called ‘Angel Tax’ in the Finance Bill 2023 is likely to have consequences far and beyond just angel investors and could influence Indian start-ups across sectors and stages. Hence, the potential return of an Angel Tax has many of the most active Indian start-up investors alarmed and astonished.

WHAT IS ANGEL TAX?

Referred to colloquially as Angel Tax, this canon is defined and described in Section 56(2)(viib) of the Income Tax Act, 1961. To stop the laundering of black money and round-tripping through investments with a huge premium into unlisted corporate entities, this clause was included in the Act in 2012. The tax embraces investment in any private business unit, but only in 2016 was it applied to start-ups. As more and more new-age tech start-ups began raising Venture Capital (VC) financing or funding, they came under the Income Tax department scrutiny. These funding agreements frequently saw investors paying a premium above the face value or the fair market value of securities and therefore were taxed as income for the start-up.

The Angel Tax is being imposed on start-ups at 30.9% on net investments over the fair market value. And many start-ups were retrospectively assessed for this tax year after their fundraising and this elevated numerous worries in the ecosystem since most did not have the cash at hand to pay this tax bill and therefore endangered being sued.

Between 2016 and 2019, start-ups pleaded with the government to add exclusions that would permit them to be exempt from the Angel Tax. In March 2019, after some force from the start-up network, an exemption was offered to start-ups under specific terms. Distinct from the tax holiday, this exemption does not require authentication by the Inter-Ministerial Board of Certification, which was established by the Department of Promotion of Industry and Internal Trade (DPIIT). Up to now, merely 1,048 start-ups from nearly 90,000 DPIIT-registered start-ups have been authenticated by the board, or only over 1% of the total base.

Picture of businessmen’s hands on white table with documents, coffee and drafts

The tax embraces investment in any private business unit, but only in 2016 was it applied to start-ups. As more new-age tech start-ups began raising Venture Capital (VC) financing or funding, they came under the Income Tax department scrutiny

But the important condition for exemption is that the total amount of paid-up share capital and securities or share premium of the start-up after the issue or intended issue of shares does not surpass ₹25 crores. It meant inhabitant angel investors who usually invest a minor amount of seed money were spared the Angel Tax. Furthermore, there was an extra exemption for the Securities Exchange Board of India (SEBI) registered Alternative Investment Funds (AIFs) and capital upraised from foreign investors because the main aim was round-tripping of funds from and to India.

Nevertheless, not all of these start-ups are yet exempt from angel tax when the total amount for the agreement is below ₹25 crores, and domestic non-AIFs investing in Indian start-ups still need to pay a tax on their agreements. What’s being amended in the Finance Bill 2023 is the exemption for overseas investors, which means any offshore fund investing in India will get affected. However, this comprises a few of the major VC investors in India, including unicorn makers such as Tiger Global, Sequoia Capital, SoftBank, and Accel, as well as early-stage investors such as Y Combinator, AngelList, and others. The exempted group of AIFs includes 1052 investors as of February 2023, many of whom do not invest in start-ups. As per approximations from AIFs makeup about 10% to 15% of start-up investments, with some even putting their share under 10%. Because of the complex nature of start-up fundraising, it is not for all time clear-cut how much a specific investor’s exposure is in any capital infusion, particularly since each round typically involves manifold investors. It is not possible to trace the range of AIF investments versus offshore funds or non-resident investors as company filings relating to fund infusions are frequently delayed by many months and even then, the actual invested amount may differ from any public claims, as reported in the case of Byju’s in 2022.

As a result of the convoluted character of VC fundraising with offshore units, numerous limited partners, and blind pools, traditionally, there has been some element of money laundering or round-tripping under the guise. By erasing the exemption for foreign funds, the new proposed Angel Tax is further eyeing to trace such transactions, where Indian individuals are limited partners in blind pool overseas funds. The Indian government does not always have visibility into the limited partners that make up foreign funds, whereas it can ask AIFs for more details relating to their investors. In 2022 it was reported that SEBI had asked AIFs to reveal whether their sponsors are domestic or overseas entities. Several investors have appealed that the 2023 Finance Bill’s suggested amendments are the government’s way of getting offshore funds to set up AIFs in India under the SEBI domain. But few industrialists believe that limitations on Foreign Direct Investment (FDI) or capital movements will be counterproductive for investments. Rather than global investors launching India-based AIFs, they might pressure Indian entrepreneurs and start-ups to move overseas and invest in those entities. In effect, it will make it easier for start-ups to take the path of flipping.

MORE TROUBLE FOR START-UPS?

Paradoxically, one day before the Finance Bill was tabled, the Economic Survey 2022-2023 had recommended steps to stop such flipping and quicken reverse flipping. It has stimulated some cheerfulness within the Indian start-up environment about making it less pricey for unicorns to move their headquarters to India. As per Inc42 data, 20 out of the 108 unicorns in India are registered overseas, and therefore, the value and Intellectual Property generated by Indian start-ups are locked up in those geographies. Hence, the extended scope of the Angel Tax has adverse consequences. It will have far-reaching connotations for the Indian start-up ecosystem as a bulk of the funds are raised from global investors, whose investments will now be subject to Angel Tax. This move may push many start-ups to redomicile overseas.

The Angel Tax is being imposed on start-ups at 30.9% on net investments over the fair market value. And many start-ups were retrospectively assessed for this tax year after their fundraising and this elevated numerous worries in the ecosystem

Even beyond the matter of taxation, the compliance load on start-ups will possibly upsurge considerably under the new regulations. Basically, while an offshore fund such as Sequoia or Tiger Global may be investing in similar entities as SEBI-registered AIFs like Chiratae Ventures, Blume Ventures, Omnivore, and Fireside Ventures, the regulations would apply differently for these investors. And this is where the disclosure load on start-ups also increases. The timing of the Angel tax is most disturbing since it accords with the current start-up funding slowdown. Valuations have already slumped from the peak of 2021, and since the Angel Tax covers the fair market value of securities, it is likely to lead to more corrections in start-up valuations. Despite the government’s bluster and boast about refining the ease of doing business in India, entrepreneurs and investors are concerned that applying strict taxes on capital receipts without adequate exceptions will lead to start-ups moving overseas.

There appears to be a decent motive for India’s start-up ecosystem to gripe about the central government’s decision to bring non-residents into the territory of its angel tax provisions. As this could sweep investments from global private equity (PE) or venture capital (VC) funds, venture capitalists, and individual Non-Resident Indians into the tax net, there is apprehension that fund-raising will be hit, stimulating domestic start-ups to domicile abroad. It looks unfair to bring in these provisions at a time when a global funding winter has shrunk PE or VC inflows into India by 29% in 2022. Capital raised from non-resident investors is subject to FEMA rules, where money can only be received through banking channels with complete Know Your Customer (KYC) norms.

Even without going into the matter of whether foreign investors ought to be in its ambit, the rationale for imposing the angel tax is fragile. Income tax is levied on the profits made by an enterprise from carrying on a business activity, and levying it on capital raised is irrational. Listed corporate entities raise capital all the time from private placements and promoter infusions without attracting any levy, so it seems unkind to levy it on blossoming ventures which require higher risk-taking by investors. To arrive at the tax liability, unlisted firms are required to compute the ‘fair market value’ of their shares by applying textbook methods such as book value and discounted cash flow, which is quite impractical or unreasonable for early-stage ventures. In 2019, maybe recognizing the rationality of such pieces of advice that this government laid back the applicability of angel tax to a few ventures. DPIIT-registered start-ups were exempted from this tax, provided they raised funds from SEBI-registered category 1 and category 2 AIFs.
One understands the initial intent of the angel tax provisions, which was to dampen the laundering of unaccounted money through unlisted firms masked as capital investments. But then this tax is also the relic of an epoch when the start-up network was not so vibrant and PE/VC investments were not such a significant driver of inbound FDI. Today, it is hard to overlook the visible value being created for the economy by genuine start-ups through innovation, value-added, and employment. Over the past decade, there has been a quantum jump in the resources, data, and technology available to the taxman to trace the money trail on suspect transactions. Therefore, the time is right for the Centre to discard angel tax and look for other means such as registration of angel investors and disclosure of beneficial ownership of PE/VC/angel funds to plug the abuse of this route.

ARE NEW EXEMPTION PROVISIONS FAVOURABLE?

The expansion of the pertinence of angel tax to shares issued to a non-resident investor resulted in fears of tax overreach being raised by legitimate, regulated non-resident investors. To tackle these concerns, the Central Board of Direct Taxes (CBDT) issued a notification on May 24, 2023, that enumerates several classes of persons who will not be covered under the amended angel tax provisions.

Foreign government and government-related investors (sovereign funds), foreign banks or regulated entities involved in the insurance business, and the SEBI registered Category-I foreign portfolio investors, endowment funds, pension funds, and broad-based pooled investment vehicles or funds with more than fifty investors (not being hedge funds or funds which employ diverse or complex trading strategies) were among those excluded. Further, residents functioning and investing from regulated nations Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Iceland, Israel, Italy, Japan, Korea, New Zealand, Norway, Russia, Spain, Sweden, the UK, and the US were also not roofed under the modified angel tax stipulation. Investors in start-up entities that satisfy the conditions stated by the DPIIT and file a self-declaration to that effect were also not covered. However, nations like Singapore, Netherlands, and Mauritius, which form the chief chunk of FDI in India, have not been included in the exemption list.

Distinctly, the CBDT issued draft valuation rules on May 26, 2023, suggesting extra valuation methods. It has been suggested that if consideration is obtained by an Indian private company from a company resident in any of the nations stated above, notification against the issue of unquoted equity shares to such entity, the price of the equity shares resembling such consideration may be considered as the Fair Market Value (FMV) of the equity shares for resident and non-resident investors subject to specific conditions. Further, a merchant banker’s valuation certificate, if it is of a date not more than 90 days before the date of issue of unquoted equity shares which are the subject matter of valuation, will be acceptable. Additionally, a payout up to 10% above the merchant banker’s valuation certificate will be accepted.

Despite the government’s bluster and boast about refining the ease of doing business in India, entrepreneurs and investors are concerned that applying strict taxes on capital receipts without adequate exceptions will lead to start-ups moving overseas

The relaxation permitted by the CBDT to several categories of investors and start-up companies is a welcome move. But, traditionally, investments by venture capital funds in start-ups have been through compulsorily convertible preference shares. Therefore, unless the draft valuation rules are extended to wrap all kinds of instruments of unlisted companies, they will not serve a complete purpose. Given that India collects substantial FDI from other regulated jurisdictions like Singapore, Mauritius, The Netherlands, Luxembourg, etc., it is unclear why such offshore jurisdictions have been kept out.
VC funds are thinking to induce the finance ministry to issue a clarification saying that VC funds based in foreign jurisdictions are exempt from the new rule. However, implementing such an exemption only for VCs (and not all foreign investors) will be difficult because several VC funds invest through vehicles based in tax havens like Mauritius or the Cayman Islands, which may not have similar regulatory prerequisites as AIFs in India. So, such an exemption might defeat the purpose of separating genuine investments from fraudulent ones.

WHAT IS THE WAY FORWARD?

Theoretically, the angel tax appears somewhat faulty because it does not account for business needs and new financing techniques, especially in the VC and PE galaxy. Introduced in 2012 as an anti-abuse measure to avert money laundering, it has inflicted chaos for several start-ups and will now do the same to multinational entities. A superior method may be to let commerce and business function easily but seek more data in a company’s tax return on how premium has been computed and whether it is market standard for such a company or business, considering international and Indian valuation standards. Training tax officers on valuation and merchant banking will also go a long way in reducing indiscriminate scrutiny.

The sound and solid regulation has always been conducive to the orderly growth of markets. It may come with some teething problems, but most Western nations are generally very particular about compliance. India needs to have a robust start-up ecosystem but that does not mean becoming an open market for value trading. The government may have a tough point to sell, but it may be good in the long run. What India needs to be careful of is that such provisions do not lead to unnecessary hounding of businesses.

Shivanand Pandit

Shivanand Pandit is an autonomous Finance and Tax Adviser, a writer by zeal and a reader by passion. He has 26 years of experience in the field of Finance, Accounting, Taxation laws, Cost management, Wealth management, Audit, Corporate and Banking laws. He has authored the books Begin To Win, Flying High, Nightingales and Beyond 2020. He can be reached at
panditgoa@gmail.com

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