[Ishita and Janhavi are students at National Law University Odisha.]
In recent years, India's start-up culture has assumed a greater significant trajectory as it has made a substantial contribution to the economic expansion and development of the nation. With approximately 27,000 startups, 25 unicorns (valued at over US$1.2 billion), and US$38 billion in consolidated investments over 2016-2020, India is credited to harbour the largest start-up ecosystem in the world. The reason behind such a wide expansion can be contributed to various factors such as skilled workforce, infrastructure, private investment (seed, angel, venture capital, private equity), access to funding, innovation ecosystem, venture capital, regulatory policies etc. Irrespective of such advancements, there are still many obstacles for Indian startups to overcome, including the unorganised and splintered nature of the consumer base, the absence of flexible and transparent regulatory framework and policy decisions, the poor infrastructure, and the inability to ingress the governmental incentives (such as tax breaks and the difficulties in conducting business).
One of the recent hurdles on the pavement of start-up companies is the expansion of the ambit of angel tax to include non-resident investors under Budget 2023. Angel tax is frequently seen as the devil in the start-up environment, despite how majestic and virtue-filled the word "angel" appears. Under Section 56 (2)(viib) of the Income-tax Act 1961, the government first implemented an angel tax in 2012. It is levied on the extra monetary gains obtained by any private company when it sells shares at a price premium to the fair market value. Prior to 2023, foreign resident investors and venture capital funds were exempted from Angle tax. But in order to maintain a parity in taxation, the Finance Bill 2023 has done away with the criterion of residency, thus making the section applicable to foreign investors. This recent tax amendment will act as a double whammy for the start-up companies that are already under the “funding winter.”
Foreign Investors as a Boon to the Start-Ups
Indian start-up companies depend mostly on foreign investment or overseas sources for their growth. Data shows that in the recent years these companies have generated a bulk of capital, where the private equity and venture capital summed up to a total of $54 billion. It should not go unnoticed that global investors like Japan's SoftBank and the US-based Tiger Global have helped a number of startups develop their operations and reach about a billion-dollar valuation. An amendment of this stature is capable of shaking the early growth of the start-up companies from its core. It will discourage international investors from making investments in India as they may not want to cope with higher tax liabilities. This would prompt the start-ups to anticipate the reorganising of their assets and relocate overseas to escape pressure from the foreign investors. Some scholars have also remarked that this amendment is counter-intuitive to reverse-flipping as this will, in itself, accelerate flipping overseas.
Impact on Issuance of Shares
Another major impediment with the latest amendment is the "deemed income provision" of the Income-tax Act 1961 that applies to specific types of property, including securities like stocks. It states that if such property is purchased for less than its fair market value (FMV), the difference between the FMV and the actual amount paid is treated as income and subject to taxation as such. According to the tax authorities, this clause also applies to shares bought through a primary offering. The share issue price must adhere to both provisions if the proposed adjustment to the angel tax provision is passed; otherwise, there may be negative tax repercussions for either the privately held company (PLC) issuing the shares or the investors subscribing to them. Shares issued to non-resident investors must also abide by the valuation standards set forth by rules governing foreign exchange management (FEMA), even if identical considerations would also apply to capital raised from non-resident investors. If adopted, the proposed modification could contradict in lines with the FEMA regulations' valuation standards and limit PLCs' ability to raise money from non-resident investors. Although the valuation guidelines provided by each provision differ, there is still some room for a tax-compliant share issuance that does not have negative effects on the PLC or the investors. However, if the suggested modification is passed, shares issued to non-resident investors would also be subject to the same tax law considerations. According to FEMA regulations, shares offered to non-residents must be issued on at least an FMV basis. The PLC will be ostensibly required to issue shares at exactly the FMV to ensure that there are no penalties under either clause, which is exceedingly restrictive and may not be commercially plausible. This clashes with the valuation ceiling specified under the angel tax provision.
Conversion of Convertible Instruments: The Aftermath
Aiming to convert the convertible securities, like preference shares or debentures, into equity shares may become more difficult as a result of the proposed modification to the Income-tax Act 1961. The conflicting decisions of the Income Tax Appellate Tribunal (ITAT) have raised questions regarding whether the angel tax provision applies to these conversion transactions. According to one of the rulings of the ITAT, it is considered that the angel tax provision is applicable to conversion transactions if all of the prerequisites are met, and the consideration received by the issuer-company can take many different forms, such as the cancellation of debt obligations, the release of asset liens, or an improvement in the debt-to-equity ratio. The ITAT has, however, also ruled that in order for the provision to be applicable, shares must be issued and payment must be made in the same calendar year. If the proposed amendment is passed, it is anticipated that these disagreements are prone to occur more frequently in the future course and that there may be valuation-related problems between the FEMA regulations and the angel tax provision.
Critical Analysis and Conclusion
It is hoped that the recent amendment with respect to angel tax is given another perspective in light of the various challenges mentioned above. The measure is likely to affect foreign direct investment in India, which is evidently not within the ambit of India’s affordability at the present instance. To evade such obstacles, the companies might attempt to hasten any present fundraising from foreign investors before the due date or the investors could also consider registering and operating through AIFs. Taking this into consideration, either the withdrawal of the said amendment or the inclusion of certain exemptions under the section could be a desirable alternative. For example, non-resident entities registered with the Reserve Bank of India, the Security and Exchange Board of India or similar regulatory authorities in their respective countries could be exempted. Similarly, Category I foreign portfolio investors under the SEBI Foreign Portfolio Investment Regulations 2019, and direct/indirect investments by sovereign wealth funds and pension funds, could also be given an exemption. Additionally, when shares are issued at a greater price than the valuation report by a Category I merchant banker, a safe harbour mechanism / tolerance limit of up to 25% may be granted. Any value disagreements that exceed the tolerance level of 25% should be forwarded to an approval panel for a fair examination.