8 mins read . 01 Jun 2023
If there is something new-age digital start-ups are really worried about, it is the return of the angel tax. The Union Budget 2023-34 explicitly extended the angel tax to non-resident investors. The Finance Bill passed in the Budget Session, went a step further. It even elaborated on the list of 21 countries that would be exempt from angel tax, implying that FDI from other sources would be automatically subject to angel tax. Of course, the idea of angel tax would only arise if the consideration paid is substantially higher than the fair market value (FMV). The big question now is whether this extension of angel tax to non-resident investors is likely to hamper the flow of FDI into Indian start-ups.
Finance Bill 2023 has explicitly exempted investors from 21 countries from the ambit of angel tax. Some of the countries included in this exempt list are the US, the UK, France, Germany, Japan, South Korea, Australia, New Zealand etc. However, some of the most popular sources of FDI for Indian start-ups have been kept out of the exempt list. Some of the countries like the Netherlands, Mauritius, Singapore, Luxembourg, UAE, and Ireland are not on the exempt list; but they account for a big chunk of FDI flows into India.
Why this dichotomy and why is CBDT distinguishing FDI based on source? CBDT has given the exemption only where it is fairly confident of the compliance and governance checks in the financial system. According to the CBDT, countries like Singapore, the Netherlands and Mauritius have been aggressive about becoming an FDI source and that has left gaps in compliance and audit trails. Hence, these countries are kept out of the exempt list. Therefore, investments from these countries will be subject to angel tax if the FMV condition is not satisfied. This is expected to hit FDI flows into start-ups for now.
Broadly, there are 4 classes of start-up flows that will be exempt from angel tax provisions, even if it translates into FDI in India.
Even if the above conditions are not satisfied, the consideration will either have to be substantially higher than the fair market value (FMV) or the gap should be something that cannot be explained with rational data.
For now, the angel tax paper is up for comments, so we need to wait for the consensus. However, it is also true that the countries with more stringent regulatory frameworks like the US, UK and Western Europe do not account for the bulk of the FDI flows into start-ups. It comes from Singapore, Mauritius, the Netherlands, UAE, and Ireland; nations subjected to angel tax. Some short-term impact is inevitable. As per the angel tax rules, if the equity investment from a taxed non-resident source is substantially higher than FMV, the excess amount will be taxed as income in the hands of the start-up. That is a worry.
Start-ups are concerned on two fronts; the momentum of FDI flows and the risk of hounding. Firstly, after nearly 18 months of funding winter, FDI flows into start-ups are starting to look up. The angel tax could disrupt that. Secondly, there is the risk of hounding start-ups and that is something that has to be avoided at all costs. India has produced over 100 unicorns and is the third largest start-up ecosystem in the world after the US and China. These advantages cannot be wasted.
Broadly, there are two grey areas for start-ups in the angel tax announcement. Firstly, on FMV calculation; there is a formula agreed upon, but discretion is inevitable. There are factors like preferential exit, anti-dilution deals and substantial control, which influence the premium to FMV. These will be very subjective areas. The second concern is convertibles. Start-ups often sell stakes to global investors via convertible debt or convertible preference shares. Even if the conversion ratio was agreed upon earlier and the conversion happens after March 2023, they would still be covered by angel tax provisions and grandfathering will not apply. In short, one can expect a spate of legal disputes in this area.
One concern is that the angel tax may force Indian start-ups to shift domicile to more friendly nations like Singapore or UAE. However, there is a positive side to angel tax. Remember, sound and solid regulation has generally been conducive to the orderly growth of markets. Most advanced Western nations have refused to compromise on compliance. While India surely needs a robust start-up ecosystem; it cannot be at the cost of compliance. More than the idea of angel tax, it is the hounding that India needs to be cautious about.
Content Source: Multiple Sources