Angel tax reforms provide clarity, but unlikely to boost capital inflow into Indian startups

The new notification by the CBDT on angel tax regulations has provided flexibility to investors to invest in Indian startups, but there are certain issues which may hamper the fund flow.

Angel tax reforms provide clarity, but unlikely to boost capital inflow into Indian startups

Friday May 26, 2023,

6 min Read

Key Takeaways

  • Angel tax will not be applicable to investor categories from overseas such as foreign portfolio investors, pension funds, sovereign funds, etc.
  • The government has sent a clear signal that foreign investors are welcome for startup investments.
  • Gives more flexibility on how startups can be valued.
  • The inclusion of a few countries under angel tax comes as a dampener.

The investor community funding Indian startups has welcomed the recent notification by the government on angel tax. While the proposed amendments to angel tax provide some flexible features and remove its purview on a certain class of key investors, it is unlikely to bring in any immediate rush of capital into Indian startups as certain niggling worries remain.

The notification by the Central Bureau of Direct Tax (CBDT) encompasses areas such as exemption, valuation, parity for investors, pricing, etc. Some of the key highlights of the proposed changes in angel tax include:

Expansion of exemptions: Previously, only alternate investment funds (AIFs) regulated by SEBI & IFSCA were exempt from angel tax. Now, CAT I, FPIs, government bodies, banks & insurance companies, university endowments, pension funds & broad-based funds with more than 50 investors will be exempt.

Valuations: Earlier, the standards of startup valuation accepted by the authorities were restricted to just two types—book value or discounted cash flow. Now there are additional valuation methodologies available, providing more flexibility.

Parity on pricing: As startups receive investments from both overseas and domestic investors, these come under regulators such as the RBI, the Income Tax department, and the Ministry of Corporate Affairs. This resulted in non-resident investors not being allowed to acquire securities below fair market value (FMV) under Foreign Exchange Regulation Act, while angel tax regulation did not allow companies to issue shares above FMV. Now, price matching with venture capital funds will be taken at FMV.

Variations: Earlier, variations in the pricing of shares of a startup could trigger angel tax, but the new notification has said 10% is acceptable.

Reports: Valuation reports now have a tenure of 90 days from the previously unspecified time period.

angel investor
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In the Union Budget, the Indian government had brought overseas investors who did not operate under the AIF framework under the angel tax net. 

This did not bode well for the Indian startup ecosystem as the majority of investment was coming from the non-AIF route, which is foreign money. This resulted in a lot of confusion and sent a negative signal to overseas investors.

However, the new notification has brought some relief to the startup community.

“There is a lot more clarity from the government now from this latest notification, which has several positives,” says Siddarth Pai, Founding Partner, 3one4 Capital, an early-stage venture capital firm.

The investor community has been putting across its point to the government that foreign investments are critical to Indian startups, and there cannot be unreasonable restrictions.

The biggest bugbear for the Indian startup ecosystem, which impacted both the investors and entrepreneurs, was how the valuation of these companies was perceived by the government authorities. Given that these startups are at a very early stage, it becomes a challenging task to assign a value.

“Valuing companies early in the life cycle is difficult, partly because of the absence of operating history and partly because most young firms do not make it through early stages of success,” Aswath Damodaran, the famed exponent of value investing from Stern School of Business, had said in a paper on valuing young startups.

Given that startup valuation is not a science, the gaze of the regulatory lenses becomes an additional burden for the entrepreneur and investor.

“In India, transactions involving the same company and the same set of investors have three different valuation requirements, which come under three different sets of regulators. This is unheard of in any other country. Rationalisation is key to the ease of doing business,” says Pai.

Further, in such an exercise, the RBI and the Ministry of Corporate Affairs accept the variation in valuation among different sets of investors, but the income tax department seeks the exact figure.

Angel tax was first introduced in 2012 to curb certain practices, as dummy companies were established to route doubtful sources of capital. Things became worse when this rule started becoming applicable to the startup ecosystem where they were questioned about the valuation.

Added to this, startups were taxed on the source of capital as against the conventional norm where they are taxed on their income.

V Balakrishnan, Co-founder, Exfinity Venture Partners, says, “The new notification provides a lot of flexibility to the investors as previous regulations were too rigid on how one could determine valuation.”

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However, there are certain worries about the new notification, especially regarding the requirement that funds that plan to invest should have more than 50 investors to be exempt from the purview of angel tax.

An investor on condition of anonymity said, “Large foreign investors do not have so many investors in their funds, and this only adds to the confusion.”

The latest notification on funds from which countries will be exempted from Angel Tax has also created confusion.

“These benefits may not be available to several large private equity funds who invest in India through jurisdictions such as Mauritius and Singapore. Also, the broad-based funds are defined as having more than 50 investors; hence it would be interesting to see whether this benefit is extended to such pooling vehicles making investments in India through specific SPVs located in non-specified jurisdictions,” says Punit Shah, Partner, Dhruva Advisors. 

The expectation is that these changes will boost capital inflow into Indian startups, but this is unlikely to happen in the present environment of funding winter. “This is very unlikely to open the floodgates of capital given the environment,” says Balakrishnan. 

The Indian startup ecosystem, which raised around $24 billion in venture capital funding for 2022, witnessed a 26% drop compared to $35 billion in 2021. In the first four months of the current year, VC inflow into Indian startups stood at $4.2 billion and is likely to end in the range of $13-15 billion for 2023.

Despite these changes initiated by the government, there will always be the fear of the tax officials. 

“The biggest problem with angel tax regulation is the tremendous discretionary power in the hands of tax officials who can dispute the valuation figures or the report,” says Pai.

Edited by Megha Reddy