The Union Budget’s proposal to include non-resident investors in the scope of angel tax has led to widespread concern in venture capital (VC) and start-up circles. This provision, under Section 56(2)(viib) of the Income Tax Act, states that any premium paid above the fair market value of unlisted company shares by an investor—Indian or foreign—will be subject to taxation. Earlier, this tax was applicable only for investments made by domestic investors.
Start-ups—on whom the tax will be levied—fear this would hit their fundraising prospects as foreign investments are estimated to make up over 90 per cent of private capital invested in them. The additional tax liability on start-ups is expected to deter foreign investors from betting on Indian ventures.
“Start-ups that raised capital would get tax notices asking them to justify their valuations against actual performance. If the divergence of the projections in the valuation report and actual performance is high, the tax officer would dismiss the valuation report and tax all share premiums as income. This would lead to tax litigation during which no investor would invest, as any capital they invest may be used to clear the company’s angel tax liability,” Siddarth Pai, Co-founder of VC firm 3One4 Capital; and Co-Chair, Regulatory Affairs Council, Indian Venture and Alternate Capital Association (IVCA), wrote in an online post.
Pankaj Makkar, MD of Bertelsmann India Investments, says that while the intent is right, the rules as prescribed could unintentionally impact cases such as convertible notes (a short-term debt utility that converts into equity).
The Budget proposal has left start-ups and investors surprised as the Economic Survey 2022-23 had placed special emphasis on simplifying procedures for capital flows to encourage India-focussed start-ups to shift their domicile to India. Many start-up founders and investors are of the view that such restrictions will give a further push to start-up flipping—a term used to describe companies setting up headquarters in overseas destinations where legal environments and taxation policies are more favourable.
Rahul Singh, Co-founder of eco-friendly products maker EcoSoul Home, says the amendment increases the risk of litigation for Indian start-ups as they primarily depend on global investors for funds. “It may also incentivise start-ups to relocate overseas to avoid paying taxes. India-registered domestic alternative investment funds are exempted from this, but a significant portion of growth- and late-stage capital is foreign in nature,” says Vinod Shankar, Co-founder and Partner of early-stage VC fund Java Capital. Start-ups recognised by the Department for Promotion of Industry and Internal Trade are exempt from taxation. But it’s not a blanket exception. Shankar says DIPP’s definition of a start-up “is narrow, and it does make it a challenge to fund Series A+ stages”.
The start-up and investor communities have appealed to the government to reverse its decision and are awaiting a favourable resolution.
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