Why a proposed change in Angel Tax has rattled Indian start-ups

What exactly is the proposed change?

The Finance Bill, 2023, unveiled by Finance Minister Nirmala Sitharaman on Wednesday, has proposed to amend Section 56(2) VII B of the Income Tax Act.

The provision states that when an unlisted company, such as a start-up, receives equity investment from a resident for issue of shares that exceeds the face value of such shares, it will be counted as income for the start-up and be subject to income tax under the head ‘Income from other Sources’ for the relevant financial year.

However, with the latest amendment, the government has proposed to also include foreign investors in the ambit, meaning that when a start-up raises funding from a foreign investor, that too will now be counted as income and be taxable.

For instance, if the fair market value of a start-up share is Rs 10 apiece, and in a subsequent funding round they offer it to an investor for Rs 20, then the difference of Rs 10 would be taxed as income.

Section 56(2) VII B of the Income Tax Act, colloquially known as the ‘angel tax’ was first introduced in 2012 to deter the generation and use of unaccounted money through the subscription of shares of a closely held company at a value that is higher than the fair market value of the firm’s shares.

Why are start-ups concerned?

The change comes as the funding for India’s startups dropped by 33 per cent to $24 billion in 2022 as compared to the previous year, according to a PwC India report released in January.

Foreign investors are a key source of funding for the start-ups and have played a big role in increasing the valuation. For instance, Tiger Global, one of the most prolific foreign investors in India, has invested in over a third of the start-ups that have turned unicorn, with a valuation of at least $1 billion.

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

“This could compel more startups to flip overseas, as foreign investors may not want to 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.