Angel tax returns, spooks India's startups

What is angel tax and why was it introduced?

Private companies that issue shares to Indian investors at a high premium to their fair market value (FMV) pay a tax on the difference under section 56 (2) VII B of the Income Tax Act. This was introduced in 2012 to crack down on ‘hawala transactions’, where people try to avoid tax on income by issuing shares at a high premium and then buying it back for a token amount. However, the tax department began applying it to startups that were raising capital from domestic private investors or ‘angels’. Till now, Sebi-registered funds and ‘non-residents’ were exempt.

What is the big budget move  around  angel  tax?

The budget moved to bring ‘non-residents’ under this section, but Sebi-registered domestic funds remain exempt. This means any private company that raises foreign money would be liable to pay tax at the corporate tax rate. If they are raising capital at a premium to their FMV, they would need to declare the difference as ‘income under other sources’. Startups are worried it will impact them disproportionately as typically, they issue shares at a high premium on the promise of high future growth. Practically, many startups have received tax demands under this section, especially over the last five years.

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What will be the impact of this change?

Companies require foreign capital and this section taxes foreign direct investment. The tech meltdown has already tempered access to foreign money. Startups have suffered after foreign funding dropped in 2022, and a new tax could worsen the blow. Investors might turn wary of startups that have received angel tax demand as the money could go to settle a tax bill.

What is the Centre’s reasoning?

The government said this section is aimed at ‘hawala’ transactions and not startups. The move would end ‘preferential treatment’ to foreign investors as Indian residents are already subject to this tax, a top government official said last week. Startups registered with DPIIT would be exempt. However, this accounts for just 84,000 startups, leaving most of the rest liable to the tax. From a government perspective, it needs to rein in fiscal deficit from 6.4% currently to 4.5% by 2025-2026 and needs to expand its source of revenue.

What are the other concerns?

A tax burden such as this could accelerate the flipping of startups to overseas destinations, if they find it cheaper. Startups that claim exemption under the law would also not be able to engage in certain legitimate business activities for seven years after they cease to be startups, which would be a struggle. Some of these include setting up subsidiaries, loan advances or salary advances, and stock M&A. On a day-to-day level, companies expect increased compliance burden and additional tax demands from 1 April, 2024.