Economic Analysis on Angle Tax for Startups Post Budget 2023

Angel tax is a prime example of how even well-intentioned actions can backfire. The difference between the issue price of unlisted securities and their fair market value (FMV), which must be calculated by a merchant banker using either the book value technique or discounted cash flow method, is taxed under Section 56(2)(viib) of the Tax Code. It was first implemented in 2012 as a “measure to prevent generation and circulation of unaccounted money” after a well-known politician’s company received an unreported 277 crore share premium.

Since 2016, the aggressive misapplication of this clause to Indian startups seeking investment has occurred. It was known as a “angel tax” since it mostly affected HNIs and family offices in India who made angel investments in businesses. it was applied on startups and not on the fund investors. Due to the fact that foreign funds make up the majority of later-stage financing, the impact was mostly limited to early-stage businesses. Indian funds’ capital investments in the biggest funding rounds of 2021 and 2022 are estimated to be in the low single digits.

Funding from foreign PE/VC firms

The budget changed this clause to include “nonresidents,” while Sebi-registered domestic funds continue to be exempt. Any private business that raises foreign capital is therefore subject to taxation at the corporate tax rate. They must report the difference as “revenue from other sources” if they are raising capital at a price higher than their FMV. Startups are concerned that it will have an unfavourable impact on them because, traditionally, they issue shares at a large premium with the expectation of rapid future growth. Specifically over the previous five years, a lot of startups have actually received tax demands under this clause.

Non-residents and alternative investment funds with Sebi registration were exempt. Despite the fact that many international investors are registered with and subject to the regulation of their own securities regulators, Budget 2023 expanded it to include them. However, their contributions would subject the firm to the angel tax. The industry does not seek parity by extending the reach of this to nonresidents. Angel tax was incorrectly applied to Indian entrepreneurs in a devious way. Tax authorities challenged valuations by contrasting them with real results. Deviations were interpreted as evidence of money laundering, drawing the section’s attention. Investors would refrain from making more investments because any funds would be utilised to pay the angel tax obligation. Due of this, many startups have failed, and entrepreneurs now prefer to launch their businesses in Singapore or the US rather than India.

There are two definitions of startups in India: one provided by the DPIIT and one by the income tax department. According to the DPIIT, a startup is a company or firm that has less than $100 million in annual revenue, has been in business for less than 10 years, and is not a subsidiary or spin-off of another entity. Through this straightforward, objective criteria, DPIIT has registered over 84,000 startups.

A DPIIT startup must be incorporated between 1 April 2016 and 1 April 2024 and be designated “innovative” by the Inter-Ministerial Board (IMB), a committee of bureaucrats, in order to qualify for income tax incentives. IMB certification is held by fewer than 1% of India’s 84,000 startups. The government’s income tax benefits, such as tax holidays, carryover of accrued losses due to shareholding changes, exemption from the angel tax, and deferral of Esop tax for employees, have not been obtained by 99% of India’s startups.

These tax advantages are purely theoretical and have no bearing on entrepreneurs. The 2023 Economic Survey made reform of this IMB framework a top priority in order to stop entrepreneurs from selling out to foreign investors. All AIF-funded startups should be eligible for tax benefits rather than IMB. Abuse can be stopped by using safeguards like a minimum investment and dematerialization of assets.

This is pushing startups to move overseas, The ecosystem is willing to combat this menace of illicit funds, but it’s sick of being the collateral damage to ill-conceived regulations being misapplied to them.