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

Foreign funding in local startups is now subject to the


Indian startups that raise capital from foreign investors such as Sequoia Capital, Softbank, Prosus, Tiger Global, Carlyle, KKR and Blackstone will now have to pay an “angel tax,” a move that could not only negatively impact the funding, but also encourage more startups to locate overseas.

Announcing the Union budget on Tuesday, the finance minister said non-residents would now fall under Section 56(2) VII B, better known as the “welfare tax”, which was introduced in 2012 as an anti-abuse measure aimed at tax evasion.

Alternative investment funds registered with the Indian market regulator Securities and Exchange Board of India (Sebi), however, continue to be exempt from angel tax.

This is likely to be difficult for startups that are already reeling from a global funding crisis, as most of the capital raised comes from foreign investors. In 2022, private equity and venture capital funding in India stood at $54 billion, while it was close to $77 billion in 2021, a record year for Indian companies.

“Non-resident investors have never been affected by this tax,” said Ritesh Kumar, Partner, J Sagar & Associates. “We all hope it’s a mistake,” he added.

Angel tax is applied if the price of the stock that is allocated to investors is greater than the fair market value (FMV) of the stock. In this case, the difference is subject to Article 56 (2) VII B. For example, if the fair market value (of a Re 1 share par value) is Rs 10 each, and if the startup allots one share with a bonus of Rs 15, then the difference of Rs 5 would be taxed as income from the startup.

Theoretically, this is likely to be more severe in the case of early-stage startups – where the divergence is higher between FMV and assigned share price. This divergence is generally less marked in mature companies.

“Up to now, startups raising foreign capital were not subject to tax as long as the shares were issued in accordance with the Reserve Bank of India’s pricing guidelines on share premium. include in the tax net any amount received by a private company (including start-ups, unless they qualify as a venture capital firm receiving investments from a venture capital fund) of a non-resident for the subscription of shares when the consideration is higher than the fair market value”, explained Kumar.

According to Siddarth Pai, co-founder of venture capital firm 3one4 Capital, this could force more startups to look overseas, as foreign investors may not want to face additional tax liability due to their investment in the startup. “The re-entry is completely counter-intuitive to the whole reverse flip move. This, in fact, will accelerate the overseas turnaround,” Pai added.

“The Angel Tax has been the sword of Damocles hanging over the heads of various Indian startups. It had been misapplied to them as all the startups ended up raising funds from investors at a high price and often the tax demand would come after a year or a year and a half. No investor would touch these startups, because any money invested in the startup would actually go to eliminate the old tax liability, “said Pai. He added that it would be taxed. for startups under “income from other sources” and that the corporate tax rate would apply.

This would also apply to domestic investors who are not AIFs registered with Sebi. “If money hypothetically came from a State Bank of India or an LIC in a startup, that would also be taxable as they are not Sebi registered AIFs,” added Pay.

To avoid the scope of angel tax, startups can file for a “Form 2 exemption”. However, according to the law, this exemption would prevent the startup from several activities such as not creating a subsidiary, and not making salary advances, rental deposits or vendor advances. Startups also cannot make cash investments or participate in equity mergers and acquisitions — claiming the exemption would hamper the startup in many ways, according to Pai.