India has long been the world leader when it comes to historically successful entrepreneurship prospects. High net worth individuals (HNIs), international funds, venture capitalists, angel investors, and many others in the investor community continue to be optimistic about the growth potential of the rapidly expanding Indian startup ecosystem.
While government programmes like Startup India, Stand-Up India, and Digital India help the Indian startup ecosystem grow favourably, the phrase “Angel Tax” continues to be a source of anxiety for the whole startup scene in India.
Significant amendments were noted in the Finance Bill of 2023 with respect to the Angel Tax. We shall discuss them in this article.
What Is Angel Tax?
Angel tax (often referred to as the “section 56(2) (vii b) tax” in India) is the tax on the capital or funding that a startup has received from an angel investor.
An angel investor, a private investor, a seed funder or an angel funder is a wealthy individual who contributes his wealth to start-up businesses or entrepreneurs who are starting off. In an effort to stop the flow of unaccounted money into the economy and avoid money laundering, the angel tax was implemented as a part of the Finance Act of 2012.
Nonetheless, the introduction of the angel tax has caused controversy because it is believed to be a significant roadblock to the development of India’s startup ecosystem. Due to the complicated rules and high tax rates associated with the angel tax, startups have had difficulty acquiring money, which has resulted in discouraged investments and slowed innovation.
Earlier vs the Finance Bill, 2023
Previously, as per section 56(2) (vii b) of the Income Tax Act, 1961, any premium received by a company (other than a publicly listed company) from a resident exceeding the Fair Market Value (FMV) of the share issued, was liable to tax in the hands of such company. Such premium exceeding the FMV shall be considered ‘income from other sources’ and hence, as a result, shall be taxable.
Now, the proposed amendment is such that clause (vii-b) of sub-section (2) of section 56 of the Income Tax, 1961 is to be amended to delete the phrase “being a resident” (the “Amended section 56”). Unlisted, privately held companies that are not substantially owned by the public will need to be on the lookout for the amended section 56 becoming applicable to share issuances to or funding from persons residing outside India once this amendment takes effect with regard to the assessment year 2024–25. (the non-residents/persons residing outside India).
The government has been continually working on the easement of conducting business in India. Companies have long raised significant FDIs from foreign non-resident investors at a premium without it affecting the tax regime or them being levied upon by taxes.
Now, these non-residents that undertake an FDI transaction are always subject to price guidelines. This is as per the FEM Rules, 2019. These rules mandate that companies shall not provide securities to a non-resident at a price that is lower than the fair evaluation of such equity instruments.
Therefore, in simple terms, the Finance Bill 2023 suggests an amendment in section 56(2) VII B of the Income Tax Act. As a result, it now involves foreign investors as well, under the ambit of tax. Hence when a startup shall raise funding from a foreign investor, that funding shall also be considered ‘income’ and will most certainly be taxable as a result of the amendment.
Will It Affect Startup Funding in India?
The amendment clearly states that the startups registered under DPIIT (Department for Promotion of Industry and Internal Trade) and other government-recognized public companies shall remain out of the purview of proposed changes. The changes shall only be applicable to private, unregistered companies in India that are not registered under the DPIIT.
As was also previously prevalent, investee firms will have to consider for all persons (not exempting non-residents) the amendments now prescribed in section 56.
It must be noted that the exempted categories remain intact for now, and it is suggested that:
- The non-resident investors may start considering setting up funds in India in the exempted categories, and
- Early-stage companies may consider procuring registration as a ‘startup’ with DPIIT and avail of the benefits of an exempted category by meeting the requirements prescribed for the same.
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