In today’s Finshots, we break down angel tax and its effect on startups in an oversimplified manner.

The Story

Many of us are still reeling from the pool of changes that the Budget 2023 brought last week. Changes in personal income taxes grabbed instant attention and everyone’s now pulling out their calculators to check how it affects their tax bills.

But there are many other amendments that the Finance Minister proposed in her budget speech that are brewing tense conversations. One such change relates to the taxation of funding raised by startups ― more popularly called an ‘angel tax’. So, today we thought we’ll make you one tax amendment smarter by breaking it down for you.

The year is 2012.

The then Finance Minister Late Pranab Mukherjee tabled a white paper on black money in his budget speech. It outlined estimations on black money and spoke of all the ways people tried to convert their black money into white through something called ‘round tripping’.

What’s that? You ask.

Imagine a filthy rich Indian. Let’s call her Madam Rich. She earns income from various sources– like real estate and jewellery business. But she also has illegal income. She invests in foreign entities. So, she finds a clever way to invest her undisclosed income overseas.

After about 5 years, she buys a lavish property from another chap. Let’s call him Mr. Wealthy. Now, they come to an arrangement where Rich and Wealthy only show 70% of the property value on paper. The rest of it is paid in black.

Rich owes this black money to Wealthy.

So she tells him to open a dummy company and issue a few shares. In return, she liquidates and uses the funds that she had earlier invested overseas to pay Wealthy for the sham shares with minimal tax implications. It will look like a genuine investment to outside observers. But in reality, she just managed to turn black money into white.

The bottom line ― she round-tripped her black money by first sneaking it out of India and bringing it back while making it all look perfectly clean.

Now that we are done with round-tripping, let’s look at angel tax. During the 2012 Budget, the finance minister introduced a new tax to tackle these kinds of shady transactions. Especially the ones that were made to look like investments in private companies.

And so whenever domestic investors bought shares in an unlisted company by paying more for it than their fair market value, then these companies would have the shell out a tax on the excess money they received over the market value for these shares.

Well, this was the government’s way of widening its tax base and also tackling black money. But in the process, it hurt small companies that were just starting out, the ones you know as ‘startups’.

See, startups struggle to find investors and when they get funded initially, they toil and use their funding to grow their business. Sure, there could be a lot of fake shell companies that are born just to whitewash illegal deals. But then, there are also a lot of genuine entities that were hurt by this tax. They’d have to keep aside a big portion of their initial capital to pay huge tax bills. This means they’d have to compromise with how much money they were left with to operate their company.

So over the years the government thought about it and introduced exemptions. For instance, this tax provision applied only to domestic investors. So if a startup received foreign funding they didn’t have to worry about the dreaded angel tax.

Also, in 2019 the government proposed to exempt some of these startups from paying this tax if they hadn’t completed 10 years of operation and had a turnover of less than ₹100 crores, while also having a paid-up share capital (the total money a company receives from shareholders in exchange for shares) not exceeding ₹25 crores. With these and a few more exemptions, startups breathed a sigh of relief.

But in last week’s budget speech, Finance Minister Nirmala Sitharaman dropped a bomb. The government removed the angel tax exemption on investments startups received from foreign investors.

So now (from April 1st, 2023), startups who get funded from individual foreign investors have to shell out an angel tax. Although the exemptions still hold good, the moment they issue shares to investors over their fair market value, the angel tax comes in screaming.

Startups obviously are having a nightmare again. And apart from companies having to bear a huge tax bill, this new amendment has created another confusion. Valuation!

See, when you talk of taxing foreign investments there are two laws that come into play ― the Foreign Exchange Management Act and the Income Tax Act. And you could arrive at very different valuations depending on the rules applicable. And valuations are a tricky subject as is.

If the government decides to enforce a strict interpretation, the tax implication could be enormous. And angel investors may shy away from funding startups altogether. Not to forget, the funding winter has already bitten a lot of startups and many are trying to survive by cutting costs.

What could this mean?

Well, startups could want to move to other countries like Singapore or the UAE and set up domicile there. In other words, India could lose foreign direct investments.

Doesn’t this sound like the government is dropping the axe on its own foot? Well maybe, but it’s also looking into ways to iron out these confusions. And that could probably hurt a little less.

Until then…

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