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The return of angel tax is nothing but an attempt to level the playing field for domestic investors that is currently tilted in favour of foreign entities, a top government official said.

The Union budget for 2023-24 has proposed to bring foreign investors within the ambit of angel tax, which is applied on the premium to the fair market value of a company’s shares when it raises capital.

The move has raised fears in the investor and startup communities that it would worsen the ongoing funding crunch, especially given that foreign private equity and venture capital investments in Indian startups fell to $54 billion in 2022 from $77 billion the previous year.

“There is no angel tax on startups. Let me be clear. (Section) 56.2 (VII B) used to have two provisions. One was the preferential treatment of foreign players. Preferential treatment has been done away with. But for startups, there is no change. A DPIIT (Department for Promotion of Industry and Internal Trade)-recognized startup will not attract angel tax if the investment is made into that," Anurag Jain, secretary of DPIIT, said at a press conference.

Alternative investment funds (AIFs) registered with the Securities and Exchange Board of India (Sebi) will remain exempt from the tax, but domestic investors not registered with Sebi must pay it unless the startup they invest in claims certain exemptions.

“It was preferential treatment for foreigners compared to domestic (investors). Is that the right thing to do? Do you want to treat foreigners more preferentially compared to domestic players? Why should we not give a level playing field?" Jain added.

Jain cited an example of a cup, which is valued at 100.

“I give it (the cup) to you, and you give me 1,000. The underlying asset does not have the value of what you are giving. This can be used for doing hawala businesses," he said, defending the premise of Section 56.2 (VII B).

Jain said there were sufficient guard rails to ensure this was not aimed at startups.

“We all understand that people invest in startups for their potential. Today, it may not be valued. But they know it will be valued like this after a while, so they invest. There is a proviso that this is not attracted for startups," Jain added.

The industry, though, says the law covers a large number of startups and investors on a practical level, which will likely worsen.

Only 84,000 startups are registered by the DPIIT, leaving out a large part of the ecosystem.

There are strict conditions for those claiming angel tax exemptions: They will not be allowed to conduct a variety of business activities for seven years after they cease to be startups.

Such activities include creating subsidiaries or advancing loans, or stock M&A, which are routine exercises for many companies.

Further, those who have received an angel tax notice typically find it hard to raise subsequent rounds of capital, as new investors worry whether the funding would be used towards paying off tax demands.

The budget proposal has many ramifications beyond the startup community, Subramaniam Krishnan, a partner at EY, said.

“Sellers will price the fund-raise depending on the demand. If it is an attractive asset, which gets multiple investors, a valuation exercise is also an exercise in price discovery. There are multiple variables and future projections used while calculating valuation based on discounted cash flow model. On a practical level, we have noticed that tax officers tend to challenge the valuation provided by companies, issuing notices asking for justification," he said.

Subramaniam added that companies must now balance between the foreign exchange management act (FEMA) and Section 56.2(VII B).

“The pricing guidelines under FEMA sets the floor price for the valuation, while Section 56.2 VII B sets the cap," he said.

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