Angel Tax and Indian start-ups

Published
3rd Feb, 2023

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’.