The much-debated tax practice of the Union government has now been extended to non-resident investors, too, by omitting ‘resident’ from Section 56(2) (VII B) of the Income Tax Act.
Finance Act, 2023 is likely to impact early-stage startups which obtain the majority of their funding from foreign investors and issue shares at premium prices
The memorandum to the Finance Bill 2023 clearly states that it applies from the Assessment Year 2024-25, which is Financial Year 2023-24: 3One4 Capital’s Siddarth Pai
The Lok Sabha on Friday (March 24) passed the Finance Bill, 2023, with as many as 64 amendments to the proposed draft, including debt fund taxation.
It is pertinent to note here that the Bill that has been passed by the lower house of the Parliament has failed to address Indian startups’ concerns regarding the provisions of the angel tax introduced in the Union Budget 2023-24.
The much-debated tax regime of the Union government has now been extended to non-resident investors, too, by omitting ‘resident’ from Section 56(2) (viib) of the Income Tax Act.
For the uninitiated, introduced back in 2012, Section 56(2)(viib) of the Act (income from other sources) talks about the provisions of angel tax. The tax is payable on capital raised by unlisted companies if the value of the shares issued to investors exceeds their fair market value (FMV).
In contrast, if the share value is less than the FMV, then the difference between the FMV and actual price is taken as “income from other sources” for angel investors, making them liable to pay a tax.
According to the Income Tax Act, a tax of 30.9% is imposed on the share premium issued by unlisted/closely held companies.
In 2019, the Indian government made certain changes in the Act to allow startups to escape the tax net if they fulfilled two critical conditions:
- The unlisted company should be registered with the Department for Promotion of Industry and Internal Trade
- The aggregate amount of paid-up share capital and share premium of the startup after issue or proposed issue of share, if any, should not exceed INR 25 Cr. This excluded non-resident investors and VCs.
Any startup not meeting any of the aforementioned conditions is liable to pay the angel tax. Now that the Bill proposes to include the consideration received from a non-resident, overseas investors are likely to get impacted.
Interestingly, DPIIT secretary Anurag Jain had earlier said that the amendment will not impact DPIIT-recognised startups.
“There is no Angel Tax on startups. Let me be clear. (Section) 56.2 (viib) used to have two provisions. One was the preferential treatment of foreign players. Preferential treatment has been done away with. But for startups, there is no change,” Jain said, addressing a press conference on February 2.
Since the category of share has not been defined, the section applies not only to equity but also to other classes of shares.
3one4 Capital’s founding partner Siddarth Pai said, “With the passing of the Finance Bill, 2023, the applicability of angel tax on foreign investors has been cemented. The only classes of investors whose investments are exempted are SEBI-registered Category I and II AIFs and IFSCA-registered category I and II AIFs (under the IFSCA FME Regulations, 2022).”
As of now, the impact of the amendment is expected to be similar to the impact of angel tax on startups when it was first introduced in 2012.
In one of his articles, Abhirup Ghosh, partner, Vinod Kothari Consultants writes that there is a dichotomy between the valuation rules under the FEMA regulations and the Income Tax Rules.
“The FEMA valuation norms provide for the minimum floor for bringing in funds from abroad, and that might not be the same as the fair value under the Income Tax Act. Therefore, if the valuation done under FEMA regulations exceeds the fair value as per Income Tax laws, one can expect scrutiny from the tax department, Ghosh writes.
Seconding Pai, Manish Khanna, the cofounder of Unlisted Assets said, “For startups in the early growth stages, where there is a greater difference between the FMV and the price of the allotted share, the impact is probably going to be more severe. As startups obtain the majority of their funding from foreign investors, this action is likely to have an effect on them.”
When Will The New Amendments Come Into Effect?
The amendment reads that it will come into “effect from the 1st day of April, 2024.” Only the issuances post-April-1, 2024, would be impacted by this.
Pai, however, clarified, “The memorandum to the Finance Bill 2023 clearly states that it applies from the Assessment Year 2024-25, which is Financial Year 2023-24. April 1, 2024 in the Finance Act refers to the Assessment year, not the financial year.”
The startup ecosystem still holds hope for exemptions to international institutional investors like VC funds, sovereign wealth funds, etc. The Centre is empowered to do so via a notification. The hope is that the notification comes before April 1, 2023, so that ongoing funding rounds aren’t impacted, Pai added.