Angel tax on foreign investors may muddle maths for startups

It may lead to potential litigation between startups raising capital and the tax authorities over the premium in valuation at which the company will pick up fresh funds, industry executives and investors told ET.

Experts said to avoid the tax, startups might consider readjusting the jump in valuation and avoid a wild swing in pricing a round– especially if the business fundamentals of the company have remained unchanged.

According to the rule, any premium paid by an investor in excess of the fair market value (FMV) of the shares of an unlisted company will be taxable in the hands of the company at a rate of 20% or above.
In the Union Budget for FY24, the central government proposed to include foreign investors under the ambit of the angel tax that till now applied to Indian residents and funds not registered as Alternative Investment Funds (AIFs).

Also read: ETtech Explainer: Has the Budget 2023-24 resurrected ‘angel tax’?

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The development assumes significance as foreign investors are a major source of funding for Indian start-up ecosystem. Venture capitalists, startups and industry experts who spoke with ET said the industry is planning to make representations to the government to exempt foreign investor structured funds from the ambit of the new rules.

Foreign investors are a major source of funding for the Indian startup ecosystem. Venture capitalists, startups and industry experts who spoke with ET said the industry is planning to make representations to the government to exempt foreign investors structured as funds from the ambit of the new rules.

Tax experts who spoke on the condition of anonymity said as per India’s foreign exchange rules, domestic companies cannot allot shares to a foreign investor at less than FMV value.

Also read | Budget 2023: scope of angel tax expanded, to cover foreign funding

“Now Indian tax law will tax Indian companies if the investment is at a price higher than FMV,” said Bhavin Shah, partner, PWC India. “So, to ensure one complies with exchange control laws and tax regulations, the investment must happen exactly at FMV determined by a valuation expert. The commercially agreed value aligning exactly with valuation determined by an expert will be a challenge.”

Startups typically adopt niche deal structures like ratchets, preferential exits and milestones. Going forward, startups will have to tweak these deal structures to keep share premiums under check, lest they end up paying steep taxes.

For instance, a startup’s term sheets often contain ‘milestones’ wherein if the company meets a particular goal, the existing investors promise to bring in additional capital at higher valuations. In ratchets, if a new investor gets allotment of shares at a lower price compared to an old investor, the latter will be entitled for a price adjustment.

Essentially, if the older investor was allotted shares at Rs 100 apiece while the other has been allotted at Rs 50, the older investor will get an additional share for each share he owns so that his investment value also comes down to Rs 100 apiece. In such deal structures, there is a potential difference in the valuation of the shares between two transactions.

Tax experts said in such cases, the tax department may take a view that the share sale happening at a higher valuation has a premium component in the price. “It will be a tightrope walk for startups as angel tax provisions have now been extended to foreign investors as it will become difficult for them to justify steep valuations,” Girish Vanvari, founder, Transaction Square. To arrive at the FMV, companies will have to commission valuation reports from experts. However, the tax department can question these valuations during assessment if they find any discrepancies.

Industry seeks exemption for broad-based funds

Industry participants who spoke with ET said extension of the angel tax provisions to foreign investors structured as funds would be a major roadblock for startup investments. Indian funds too are worried as they rely on the likes of Sequoia Capital, SoftBank, Prosus, Tiger Global to lead growth-stage funding rounds in their portfolio firms. While foreign individuals including persons of Indian origin (PIO) being subject to the angel tax provisions is not the point of contention, they want the funds which pool money from a wide base of investors to be exempt from the provisions.

“Valuation is a negotiation between a startup and their investors; hence the government needs to ensure that the money is coming in from proper channels, and that is something the banks do through KYC process,” said Mohandas Pai, cofounder and partner at Aarin Capital. “For that, there is no need for the government to give more powers to tax officials,”

“Most capital coming to Indian startups is from foreign investors. They are not Sebi-registered AIFs but have respective registration in their domicile markets like the US and Singapore. They have gone through the process there and bringing them under this tax ambit won’t help anyone, especially the Indian startups. This will be communicated to the government as an industry view,” one of the venture investors working on the petition to the government, told ET.

Another industry executive said if such restrictions are brought in, many companies may choose to shift their base to overseas jurisdiction through holding company structures.