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3rd February 2023 (6 Topics)

Angel Tax and Indian start-ups

Context

The Finance Bill, 2023 has proposed to amend Section 56(2) VII B of the Income Tax Act.

Section 56(2) VII B of the Income Tax Act, also 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.

What is Angel Tax?

  • It is a 30% tax that is levied on the funding received by Startups from an external investor.
  • However, this 30% tax is levied when Startups receive angel funding at a valuation higher than its ‘fair market value’.
  • It is counted as income to the company and is taxed.
  • Angel tax was introduced in 2012, with the purpose of keeping money laundering in check.

About the proposal:

  • As per the proposal under the finance bill 2023, the start-ups, that offer their shares to foreign investors, may have to pay ‘angel tax’, which was earlier only supposed to be paid for investments raised by resident Indian investors.
  • The move could adversely impact financing available to the start-ups, which have already been reeling under a funding winter since 2022.
  • The provision states that when an unlisted company, such as a start-up, receives equity investment from a resident for the 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 rises funding from a foreign investor, that too will now be counted as income and be taxable.

Why are start-ups concerned?

  • The change comes as the funding for India’s start-ups dropped by 33 per cent to $24 billion in 2022 as compared to the previous year.
  • Foreign investors are a key source of funding for start-ups and have played a big role in increasing the valuation.
  • Startups and reverse flipping:
    • Several challenges start-ups faces, such as funding hurdles, revenue generation struggles, lack of easy access to supportive infrastructure, and a complex regulatory tax environment.
    • As many start-ups have been headquartered overseas, especially in destinations with favourable legal environments and taxation policies, technically known as ‘flipping’.
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