Finance Minister Nirmala Sitharaman suggested moving up the date of incorporation for start-ups in order to qualify for income tax incentives from March 31, 2023 to March 31, 2024 in her budget address. The FM also suggested making the benefit of carrying over losses for new firms 10 years long in her budget address. This will give startups greater financial security and help them expand their enterprises by allowing them to carry forward their business losses for ten years instead of the prior five, said reports. However, the popular deal structures and valuation strategies of Indian start-ups may be impacted by the expansion of angel tax rules to overseas investors in India.
What is Angel Tax?
The extension of these regulations to overseas investors could increase the tax burden on start-ups, thereby influencing their valuations and funding arrangements. Angel tax is a tax assessed on capital raised by firms from angel investors. This is thought to have repercussions for the Indian startup ecosystem as a whole, making it harder for start-ups to raise capital and expand their operations, a report by Times of India said.
It is the tax imposed under Section 56(2)(viib) of the Income Tax Act of 1961 (the Act) on capital raised by privately held companies through the issuance of shares to a resident, the consideration for which exceeds the face value and the Fair Market Value (FMV) of the shares issued. In the startup community, this tax is more commonly referred to as the “Angel Tax.” The rich individuals (referred to as “angels”) who make significant investments in start-ups and hazardous businesses during their early phases, before they have gained widespread recognition, give rise to the term “angel tax,” explained an Outlook report.
Justification for the Angel Tax
The main goal of this taxation is to implement measures to tax private corporations’ excessive share premiums obtained above and beyond the FMV, which were frequently utilised as a cover for previously unexplained funds and as a means of collecting corporate kickbacks. This is essentially one of the anti-abuse rules that was implemented to stop money laundering, the report says.
What is the Proposed Change?
Sitharaman included in her budget presentation a proposal to change Section 56(2) VII B of the Income Tax Act.
According to the provision, any equity investment received by an unlisted company, such as a start-up, in exchange for the issuance of shares from a resident that exceeds the face value of those shares will be counted as income for the start-up and be subject to income tax under the heading “Income from Other Sources” for the applicable financial year, said a report by Indian Express.
The government has recently suggested expanding the scope of the law to include overseas investors, which means that any money a start-up receives from a foreign investor will now be considered income and subject to taxes.
According to a PwC India analysis published in January, the transition occurs as funding for India’s startups declines by 33% to $24 billion in 2022 compared to the prior year, the report said.
Foreign investors are an important source of capital for startups and have significantly raised their valuation.
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