How the angel tax harms Indian startups

This section has been in force since 2012, and in broad terms, is supposed to prevent money-laundering. It directly affects startups. If an unlisted startup issues shares at a valuation deemed to be above its fair market value (FMV), it is liable to pay 30.9% tax on the amount that exceeds the FMV. There are, however, multiple exemptions and qualifications.

Let’s say for example that a startup has sold 100 shares at ₹100 each to raise ₹10,000 and the FMV of those shares is estimated to be ₹5,000. The startup will have to pay ₹1,545 as tax on the ₹5,000 it has received in excess of the FMV. It is called ‘angel tax’ because early-stage investors are often referred to as ‘angels’.

The tax is designed to discourage scamsters from creating startups that set an arbitrarily high valuation to absorb black money from shell entities. While nobody can argue against the goal of preventing money-laundering, this tax has been controversial since inception. It has been amended and clarified multiple times but the central problems with it have been ignored.

Initially, only businesses that received investments from resident Indians (companies or people) were liable to pay this tax. Even these startups were exempt if they registered under the DPIIT (Department for Promotion of Industry and Internal Trade), which would scrutinise their finances and pass on a request for exemption to the Income Tax Department. This burdened companies with a lot of paperwork – at the very least – for an exemption.

The easiest way to avoid this tax was to find investors abroad. Then, in the 2023-24 budget, the government decided to bring startups funded by non-resident Indians and other overseas investors into the tax net. After an outcry, the CBDT issued more clarifications and exemptions.

Startups that receive investments from 21 specific nations, sovereign wealth funds (investment vehicles run by governments), multilaterals (such as the International Finance Corporation), certain classes of pension funds, mutual funds, some other pooled wealth funds, and category-1 foreign portfolio investors (FPIs) registered with Sebi will continue to be exempt. (Russia which is increasingly under wide-ranging sanctions, is exempted. China is not.)

However, Singapore, Mauritius, Holland, Ireland and The Cayman Islands are not in the list of exempted nations, though the vast bulk of investments into Indian startups comes from these places. Indeed, even US investors tend to route their investments into India via Mauritius or Singapore.

The aim of the code is to identify sources of funds as legitimate and ensure startups don’t inflate their valuations. Many of the whitelisted nations have good systems to identify money-laundering.

But there are still multiple problems at the heart of the tax. The existence of the rule is in itself a hindrance to raising capital, especially when global conditions are tight. This may have contributed to the ongoing “funding winter".

Another problem may disturb nationalists in particular. If a startup has Indian investors it is liable to cough up taxes. Thus, startups look to raise funds abroad, which means overseas investors end up owning the lion’s share of these companies. The tax, therefore, penalised Indian capital. By adding overseas capital to the net, it will now penalise all investors.

But the biggest problem of all is that setting FMVs for unlisted startups is a subjective, error-prone exercise. The CBDT initially allowed two methods of assessing FMV and multiple startups received tax notices because neither method was suitable. One involved discounted cash flows, which required startups to make assumptions about an uncertain future. The other method used net asset value, which was problematic for asset-light startups. The latest draft allows for many more methods to assess FMV. Although this flexibility helps, FMV calculations will always have margins of error.

Startups – even those that become household names – can be in losses for many years. Early-stage investors bear this risk hoping for big returns. Flipkart, for example, launched in 2007 and still makes losses. Paytm, too, is loss-making. Amazon was loss-making for its first six years. Uber launched in 2010 and is still loss-making. So are Ola and Zomato.

Startups raise money by pitching a business plan and bargaining with investors. Being forced to assess FMV is thus not just an additional headache – it also makes bargaining harder. There is also the very real fear of receiving tax notices down the road.

The angel tax goes against the very concept of ease of doing business. It is impossible to calculate the opportunity cost from all the businesses that have received funds thanks to this red tape, but there’s no doubt it’s substantial.