The Finance Bill 2023 and its Impact on Angel Investors

Ankita Tiwari

31 Mar, 2023

India is the hub for the start-up ecosystem in the world. Many new start-ups have flourished in India. Indian Government has taken initiatives such as Start-up India, Stand-up India, Digital India, etc to give a push to the Indian start-up ecosystem. These start-ups are generally funded by high-net-worth individuals who invest their personal income in business start-ups or small to medium scaled companies. Such investors are known as angel investors. The Finance Bill introduced an angel tax provision which will come into effect from 1^st April 2024. 

What is Angel Tax?

• The Income Tax payable on the capital raised by unlisted companies by the issue of shares through off-market transactions is known as Angel Tax.
• Angel tax is levied when the capital is raised by the issue of shares by an unlisted company from an Indian investor and when the share price of the issued shares is more than the fair market value of the company. The amount above the fair market value is considered as income therefore, it is taxed. The reason behind terming it as ‘Angel Tax’ is that such income largely affects angel investors.
• Angel Tax derives its base from section 56(2) (viib) of the Income Tax Act, 1961^[1]. Section 56(2) (viib) was inserted in the Income Tax Act by the Finance Act, 2012.
• The purpose of inserting Section 56 (2) (viib) was to prevent the circulation of unaccounted money as a share premium. Though this provision applies to all types of shares, issuance of convertible debentures does not attract such provisions. This provision levies taxes on any investment received by any unlisted Indian company if the value of such investment exceeds the fair market value.
• The amount above the fair market value is treated as ‘Income from other sources’ and angel tax is imposed on such income. Angel Tax is levied at the rate of 30.9% on net investments above the fair market value.
• Before the amendment was brought in by the Finance Act of 2023, Angel Tax was imposed only on those investments which were made by a resident investor and did not apply to investments made by any non-resident or venture capital funds. Further, the government of India had exempted investments made by domestic investors in companies approved by an inter-ministerial panel from Angel Tax.
• To meet the criteria for angel tax exemption the following had to be met:
• Paid-up capital and share premium of the start-up should not exceed Rs. 10 crores after the issue of shares.
• Start-ups should procure the fair market value certified by a merchant banker.
• The investor should have a minimum net worth of Rs. 2 crores and the average income in the last 3 (three) years should be Rs. 50 lakh or more.
• Approval for a start-up should be granted by 8 a member inter-ministerial board for angel tax exemption.

What is the amendment in terms of Angel Tax brought by the Finance Act of 2023?

The Finance Act, 2023 expands the applicability of section 56(2) (viib) to receipt of premium for the issue of shares from any person irrespective of the residency status thereby extending the fair market value principles to the issue of shares for the investment made by non-residents in a domestic company.

The amount which exceeds the Fair Market Value is liable to be tax in the hands of the start-up company. The purpose of extending this provision to non-resident investors is to bring parity in taxation.

In India, even the foreign exchange pricing guidelines restrict the shares issued to non-resident investors to be below the fair market value (FMV). It acts as a price floor. Now after the amendment, even the angel tax seeks to tax the amount in excess of the FMV as income in the hands of the company so the only lucrative option left with the company would be to procure investment exactly at FMV of the shares. 

Impact of Angel Tax on Angel Investors?

• After the amendment, any investment by a Non-Resident in shares of a domestic company shall require an Income Tax Valuation report from a Merchant Banker.
• The valuation report is required irrespective of the fact that investment is made by way of the Right issue or a preferential issue of shares by non-residents. It should be kept in mind that the investment does not exceed the FMV of shares of the domestic company to avoid tax implications.
• Now the investments made by NRI or strategic investments in private limited companies would require justification under Income Tax.
• Further, the valuation norms under FEMA prescribe that all investments in equity shares by a non-resident have to be valued higher than the FMV under FEMA.
• The amendment might deter foreign investors from investing in India. It might also lead start-ups to restructure their overseas holding to avoid pressure from concerned foreign investors. To some extent, this amendment goes against the aim of the Indian government to encourage foreign investment in Indian companies. It complicates fundraising by foreign investors in India and the conversion of convertible instruments.
• Further, only two classes of investors are exempt from Angel Tax, they are: SEBI registered CAT I and II AIFs and IFSCA-registered CAT I and II AIFs (under the IFSCA FME Regulations, 2022). Apart from this, there is no exemption for foreign investors so the funds collected for start-ups from non-residents will be taxed as income.
• So Indian government may consider withdrawing the proposed amendment to section 56 (2) (viib) or the government may think of providing exemptions. Otherwise, the unlisted Indian companies might be forced to explore other alternatives which could be explored to lessen the impact of the proposed amendment.

Conclusion

The levy of angel tax depends upon the FMV of the company. The income tax department goes by the rule book to calculate the FMV but the start-ups generally determine it by looking at the growth prospects and future projections of the FMV. The difference in the method of calculation might lead to the imposition of angel tax by start-ups. The tax rate of Angel tax is also high. Further, the government hasn’t even provided for any exemptions in angel tax. This discourages non-resident investors from investing in start-ups in India and encourages them to look for alternatives.

Also Read:
How to Raise Angel Funding in a Start-up?
Difference between Angel Investors and Venture Capital