Tax bites: How changes to these tax provisions can affect funding flow to India's start-ups

India is the third largest start-up ecosystem in the world with more than 90,000 such firms, and over 100 unicorns. To “build a strong ecosystem for nurturing innovation and [start-ups]”, the Indian government launched the Startup India programme in 2016, and one would have expected that regulatory provisions would be fully aligned with that aim. On the contrary, the start-up ecosystem has been caught in the cross hairs of a tax provision, ‘angel tax’ in popular parlance, which has turned into its Achilles heel. In fact, a new twist introduced recently may end up increasing the pain, in what is a classic case of a provision being brought in to curb the mischief of some that ends up hurting the industry.

Introduced in 2012, angel tax seeks to curb the generation and circulation of unaccounted money disguised as excess share premium. Simply put, the law states that a company will be taxed for any consideration it receives for issuing shares in excess of the fair market value (FMV). This particularly impacts start-ups raising funds from non-qualified or non-institutional investors, and hence the name angel tax.

This has become a dreaded provision, epitomised by thousands of litigations and tax demands running into hundreds of crores. Indeed, the pain has been so severe that not a year has gone by when the industry has not sought its abolition. But contrary to expectations, the Amrit Kaal Union Budget of 2023 widened the scope of this tax: When introduced, it covered only investments made by resident investors; it now covers investments made by non-residents too.

One major concern pertains to valuation. Income tax rules prescribe two methods of arriving at the valuation of a company’s unlisted shares: one, net asset value (NAV) per share, or two, the discounted cash flow (DCF) determined by a merchant banker, which estimates valuation using a company’s expected future cash flows. For start-ups, valuation is usually a function of their growth perception and, at times, can be driven by euphoric expectations of the disruptions they could cause. Traditional valuation methods are, thus, not suitable and the DCF method may not always apply as it may not be easy to make accurate projections.

And there lies one of the reasons for the disputes—the discretionary powers granted to tax authorities to reject such valuations, all done in hindsight. There is a certain amount of undeniable fickleness to the way start-ups are valued. Timing plays an inevitable role and, often, by the time assessments are made, some froth may evaporate, deepening the valuation gap and, thus, the pain.

For foreign investors, there is the added requirement of complying with foreign exchange pricing guidelines that state that shares can only be issued to such entities at or above the FMV, which is to be computed as per internationally accepted methods—usually DCF or a weighted average of values as per different methods, including DCF. While these guidelines prescribe a floor price, angel tax on non-residents states that any amount received in excess of the FMV will be taxed as income in the hands of the company. Hence, companies will have to raise funds exactly at the FMV of the shares to comply with both the foreign exchange regulations and tax laws. Such limitations leave little headroom for a pricing range, and could adversely affect negotiations.

A few days ago, some relief was proposed by the Ministry of Finance after protests and representations made by stakeholders. Through a notification, it excluded certain classes of non-resident investors, including government and government-related investors, banks, and entities involved in the insurance business. In an annexure, it also listed 21 countries and entities from those countries that were excluded from the provisions. These included Sebi-registered Category-I FPIs, some endowment funds, pension funds, and broad-based pooled investment vehicles—entities that are subject to a robust regulatory framework in their host jurisdictions.

It also proposed an overhaul through the draft rules on valuation for non-resident investors by including five additional methods often used internationally to value start-ups, apart from NAV and DCF. A safe harbour of 10 per cent variation in value to account for foreign exchange fluctuation has also been proposed, apart from bidding processes and variations in other economic indicators. The concept of ‘price matching’ upon fulfilling certain conditions has also been proposed. These draft rules will likely address some concerns, though not all.

On the flip side, while the government has excluded certain companies that fall within the definition of start-ups from these provisions, the devil is in the details. A reading of the fine print suggests that the definition is very restrictive, making it challenging for most entities to qualify. Thus, the exemption is seemingly only on paper.

Another point of contention could be the possibility of past transactions being questioned, and tax liabilities imposed on them. This could hinder the influx of funds as investors would be wary of their capital being used to clear tax liabilities. While the authorities have assured that bona fide investments will not be impacted and the proposed changes will certainly help the cause, it remains to be seen how they are taken to fruition. The irony of such provisions, however well-intentioned, is that they often drive good money out. Lacking clarity and flexibility, entities may externalise their structures. Provisions like angel tax and factors like the ability to raise capital may encourage start-ups to relocate abroad.

Since investments by Category-I or Category-II alternative investment funds (AIFs) have been excluded from these provisions, there may be more investments through this route. Angel investors and family offices often fund start-ups in their early stages before AIFs and other institutional investors come in. Investments from all such non-institutional investors may be directly impacted by the angel tax provisions. At a macro level, this will adversely impact capital flows to the start-up ecosystem, which is already grappling with low funding amid a global recession.

While it is essential to ensure that the tax system is not open to abuse, it is crucial to strike a balance and evaluate the impact of tax policies on the investment climate. There are ample provisions in tax laws and foreign exchange regulations supported by robust data analytics to identify mischievous investments and penalise them. One cannot help but wonder if angel tax, especially in the case of bona fide investments in start-ups by non-residents, is even warranted. There has been a growing case for scrapping it altogether.

Tax certainty is the need of the hour. Finding solutions that balance the need for tax revenue with that of promoting investments will go a long way towards improving the ease of doing business in India. 

The writer is CEO of Dhruva Advisors LLP. Views are personal