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MUMBAI : Indian startups raising capital from foreign investors such as SoftBank, Sequoia Capital, Prosus, Tiger Global, KKR and Blackstone will now have to pay angel tax in a move that could squeeze funding into the sector facing a liquidity crunch and prompt more startups to shift overseas.

Finance minister Nirmala Sitharaman said in the budget speech that non-residents will now come under the purview of Section 56(2) VII B, also known as angel tax, which was introduced in 2012 as an anti-abuse measure aimed at tax avoidance.

Alternative investment funds registered with the Securities and Exchange Board of India (Sebi) will continue to be exempted from the tax. However, foreign investors who were earlier outside the tax’s purview have now been brought under the ambit of angel tax.

The step is likely to impact startups as they raise bulk of the capital from foreign investors. In 2022, private equity and venture capital funding into India totalled $54 billion, while it was close to $77 billion in 2021, a record year for Indian firms.

“Non-resident investors were never under the scope of this tax," Ritesh Kumar, Partner, J Sagar & Associates, said. “We are all hoping that this is a mistake," he added.

Angel tax is applied if the share price that is allotted to investors is at a premium to the fair market value (FMV) of the share. In this case, the difference is subjected to Section 56 (2) VII B. For instance, if the FMV (of a 1 face value share) is 10 apiece, and if the startup allots a share at a premium of 15, then the difference of 5 would be taxed as income at the hand of the startup.

The impact is likely to be more severe for early to growth stage startups – where the divergence is higher between FMV and the price of the share allotted. This divergence is usually less stark in mature companies. Kumar said the government’s decision “proposes to bring into the tax net any amount received by a closely-held company (including start-ups unless they qualify as a venture capital undertaking receiving investment from venture capital fund) from a non-resident towards subscription of shares where the consideration is higher than the fair market value". 

“This could compel more startups to flip overseas, as foreign investors may not want deal with additional tax liability by virtue of their investment in the startup," said Siddarth Pai, co-founder of VC firm 3one4 Capital. “The re-introduction is completely counter-intuitive to the entire move of reverse-flipping. This, in fact, will accelerate flipping overseas," Pai added.

“Angel tax has been the sword of Damocles hanging over the heads of various Indian startups. This had been misapplied to them because all startups end up raising money from investors at a premium and often tax demand would come after one or one-and-a-half years. No investor would touch these startups because any money they put into the startup would actually go towards clearing the older tax liability," Pai said. He added that this would be taxed for startups under “income from other sources" and corporate tax rates would apply.

The tax would also apply to domestic investors who are not Sebi-registered AIFs. “If money came in from hypothetically a State Bank of India or LIC into a startup, that would also be liable to tax because they’re not Sebi-registered AIFs," Pai added.

To avoid the purview of angel tax, startups can file a “Form 2 Exemption". However, according to the law, this exemption would prevent the startup from undertaking many activities such as setting up a subsidiary, making any advances of salary, rental deposits, and vendor advances. Startups also would be barred from making treasury investments or participating in stock merger and acquisition deals as claiming the exemption would hamper the startup in many ways, according to Pai.

ABOUT THE AUTHOR
Ranjani Raghavan
Ranjani Raghavan writes about the Indian investment ecosystem with a focus on venture capital, private equity and startups. Outside of work, she enjoys sketching and birding. You can find her @ranjanir_
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