Foreign funding in local startups now subject to ‘angel tax’

Indian startups elevating capital from international buyers reminiscent of Sequoia Capital, Softbank, Prosus, Tiger Global, Carlyle, KKR and Blackstone, will now have to pay ‘angel tax’, a transfer that won’t solely adversely affect funding but in addition immediate extra startups to find abroad.

While saying the Union Budget on Tuesday, the finance minister mentioned non-residents will now come below the purview of Section 56(2) VII B, higher often known as ‘angel tax’, which was launched in 2012 as an anti-abuse measure that was aimed toward tax-avoidance.  

Alternative funding funds registered with India’s market regulator Securities and Exchange Board of India (Sebi), nevertheless, proceed to be exempted from angel tax.

This is probably going to be difficult for startups which are already reeling below a world funding crunch, as the majority of the capital raised them is from international buyers. In 2022, personal fairness and enterprise capital funding into India amounted to $54 billion, whereas it was shut to $77 billion in 2021, a document 12 months for Indian companies.  

“Non-resident buyers have been by no means below the scope of this tax,” Ritesh Kumar, Partner, J Sagar & Associates, mentioned. “We are all hoping that this can be a mistake,” he added.  

Angel tax is utilized if the share value that’s allotted to buyers is at a premium to the honest market worth (FMV) of the share. In this case, the distinction is subjected to part 56 (2) VII B. For occasion, if the honest market worth (of a Re 1 face worth share) is Rs 10 apiece, and if the startup allots a share at a premium of Rs 15, then the distinction of Rs 5 can be taxed as revenue on the hand of the startup.

Theoretically, that is seemingly to be extra extreme in the case of early to development stage startups – the place the divergence is increased between FMV and the value of the share allotted. This divergence is often much less stark in mature-companies.  

“So far, startups elevating international capital have been exterior the purview of taxes so long as shares have been issued in compliance with the Reserve Bank of India’s pricing tips on share premium. This proposes to deliver into the tax web any quantity obtained by a closely-held firm (together with start-ups except they qualify as a enterprise capital enterprise receiving funding from enterprise capital fund) from a non-resident in direction of subscription of shares the place the consideration is increased than the honest market worth,” Kumar defined.  

This might compel extra startups to flip abroad, as international buyers might not need take care of extra tax legal responsibility by advantage of their funding in the startup, in accordance to Siddarth Pai, cofounder of VC agency 3one4 Capital. “The re-introduction is totally counterintuitive to the complete transfer of reverse-flipping. This, in truth, will speed up flipping abroad,” Pai added.

“Angel tax has been the sword of Damocles hanging over the heads of varied Indian startups. This had been misapplied to them as a result of all startups find yourself elevating cash from buyers at a premium and infrequently tax demand would come after one or one-and-a-half years. No investor would contact these startups as a result of any cash they put into the startup would really go in direction of clearing the older tax legal responsibility,” Pai mentioned. He added that this is able to be taxed for startups below “revenue from different sources” and company tax fee would apply.  

This would additionally apply to home buyers who aren’t Sebi-registered AIFs. “If cash got here in from hypothetically a State Bank of India or LIC right into a startup, that might even be liable to tax as a result of they are not Sebi-registered AIFs,” Pai added.

To keep away from the purview of angel tax, startups can file a “Form 2 Exemption”. However, in accordance to the regulation, this exemption would forestall the startup from a number of actions reminiscent of not establishing a subsidiary, and never making any advances of wage, rental deposits, or vendor advances. Startups can also’t make treasury investments or take part in inventory M&A – claiming the exemption would hamper the startup in some ways, in accordance to Pai.