On January 31, the government’s annual Economic Survey painted a picture of reform for a ghar wapsi of Indian start-ups which had moved abroad.
It suggested multiple changes in the taxation regime and capital flow regulation to encourage young companies to shift their domicile back to India.
Startups and investors saw it as a precursor to bigger things. Perhaps, their long-standing demand of taxing the returns of investments in private firms at the same rate as their listed counterparts was on the horizon. Or that of simplifying the tax regime around employee stock options.
But that was not to be. To make matters worse, the government actually went on a reverse gear on startup reforms the following day as it announced the budget.
In an about-turn that no one in the startup ecosystem saw coming, the government seems to have tightened the noose on foreign funding for startups even as the sector grapples with a funding crunch with no end in sight.
It has mandated that the so-called angel tax regime will now also apply to money flowing into Indian startups from abroad. Here’s what you need to know about the change that has everyone from startups to venture capital (VC) investors concerned about the fate of funding in the sector:
What is the angel tax?
The angel tax regime was originally started in 2012 as an anti-abuse measure to prevent money laundering. It mandated that a startup’s fundraise from angel investors could be taxed whenever the funding round happened at a valuation more than the fair value of shares. Tax authorities treat the premium paid by investors as income, taxable at about 31 percent.
Over the years, startups and investors have spoken of being troubled by taxmen because of this provision even in the case of genuine investments. Startups have said that they received tax notices on angel investment raised 3-4 years prior. In some cases, the sum that the startups were to cough up as tax and late payment fees exceeded the original funding amount.
At the height of the angel tax imbroglio in 2019, a survey by LocalCircles showed that over 73 percent of startups that had raised capital between Rs 50 lakh to Rs 2 crore in India have received angel tax notice(s) from the income tax department.
What changes now?
Funding from two classes of startup investors were exempt from the angel tax regime till now — VC firms registered as alternative investment funds (AIF) in India, and all foreign investors.
In an amendment via the finance bill of Budget 2023, the government has removed the exemption for foreign investors. According to industry executives, as much as 90 percent of startup investments made in India are from foreign sources.
“It will be an impediment for some of the biggest foreign investors in Indian startups. An analysis of the funding rounds from 2022 and 2021 shows Indian investment at low single digits in these rounds. Placing these restrictions on foreign capital without any exceptions will be detrimental to startup funding,” said Siddarth Pai, Managing Partner of VC firm 3One4 Capital.
The concession that isn’t?
In the union budget of 2019, the government eased the angel tax rules by mandating that DPIIT-registered start-ups would be exempted from the provision. But the fine print showed that it was not a blanket exemption for all such startups. It applied only to those certified by a government body called the Inter-Ministerial Board (IMB).
The IMB is a bunch of bureaucrats who certify whether a startup is innovative and worthy of receiving benefits under the Income Tax Act, 1961. Out of the 84,000 startups registered with the Department for Promotion of Industry and Internal Trade (DPIIT) as of date, less than 1 percent are IMB-certified.
As the new angel tax provision caused an uproar in the startup ecosystem following the budget, top bureaucrats have said publicly that it would not apply to DPIIT-registered startups. But, it remains to be seen whether they mean all the 84,000-odd young companies or just the 1 percent of them.
What will be the broader impact?
The exemption from angel tax places onerous restrictions on startups, such as the ability to make salary advances, engage in stock M&A, create a subsidiary, or contribute to an ESOP trust, said Pai. Another adverse impact may be that entrepreneurs – alarmed at the re-emergence of angel tax — could seek to move overseas where such restrictions do not apply.
What is the way forward?
Industry executives are hopeful that the government will see reason and budge. VC funds are expecting to convince the finance ministry to issue a clarification saying that VC funds based in foreign jurisdictions are exempt from the new rule.
However, implementing such an exemption only for VCs (and not all foreign investors) will be problematic because several VC funds invest through vehicles based in tax havens like Mauritius or Cayman Islands, which may not have similar regulatory requirements as AIFs in India. So, such an exemption might defeat the purpose of separating genuine investments from fraudulent ones.
