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THE INTERSECTION OF ANGEL TAX, FEMA & INCOME

TAX: Navigating the Regulatory Landscape for Indian Startups

-Samay Jain & Vaanya Mathur

Abstract

This research paper talks about the repercussions of Budget 2023 on Angel tax, that is levied
on angel investors who wish to invest in start-ups. From its inception, the tax has been chastised
by investors, industry experts, and businessmen for being burdensome and hostile to startups.
They claimed that establishing a startup's fair market value was opinionated and therefore could
not be generalised because a startup's worth might be founded on anything as simple as
predicted returns at a specific moment and is susceptible to discussions between the business
and the investor. The Union budget for 2023-24 proposes bringing foreign investors within the
jurisdiction of the angel tax, which is levied on the premium to the fair market value of a
company's shares whenever it raises cash. Concerns have been expressed in the investor and
startup sectors that the decision will exacerbate the current fiscal crisis, particularly considering
that equity and capital investments in Indian businesses have fallen to $54 billion in 2022,
down from $77 billion the previous year. Another issue was that the assessing officer, a crucial
tax authority who checks the files, would use cash discounted flow to estimate fair market
value, which was not considered to be good practice for startups. The overall goal of such
taxation is to enact mechanisms to tax the extra share premium obtained by private enterprises
beyond the FMV, which was widely employed as a tool for accounting for previously
unexplained money and receiving corporate bribes. This is essentially a part of anti-abuse rules
established with the goal of avoiding money laundering. This research paper takes a look at
various news articles, websites and blogs to study the effects of this proposal on the startup
arena.

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Introduction

The term "Angel Tax" is a tax levied on funds collected by businesses through angel
investments, which is charged when the share price of issued shares surpasses the company's
fair market value (FMV). This additional realization is classified as income and taxed
accordingly. The Angel Tax was introduced in 2012 as a measure to prevent the generation and
circulation of unaccounted money.

The Angel Tax was inspired by section 56(2)(viib) of the Income Tax Act, 1961. The law
mandates Indian private corporations to pay tax on the proceeds of sale for the issuance of
shares that exceed the actual market value of such shares. Previously, Indian private firms were
only obligated to pay taxes under Section 56(2)(viib) when shares were offered at a premium
to Indian resident investors.

The Finance Bill, 2023, proposed a modification to the clause, colloquially referred to as 'Angel
Tax.' The modification would eliminate the term "being a resident" from Section 56 of the
Income Tax Act of 1961. When this modification comes into force in connection to the
assessment year 2024-25, unregistered, private equity firms (not those in which the public is
significantly concerned) must be aware that the amended Section 56 would also apply to share
issuances to or financing from individuals resident outside India (the "Non-residents").

The applicable provisions allow the assessee to determine the fair market value of equity shares
using either the net asset value technique or the cash flow discounting methodology. The
intention of Angel Tax was to prevent the circulation of unaccounted money, but it has
unintended consequences that impact angel investors who invest in companies. The proposed
modification in the Finance Bill, 2023, aims to ease the burden on startups and promote
entrepreneurship.

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Does the Angel Tax harm start-ups' efforts to raise money?

According to the proposal , the excess premium earned by any unlisted company(start up) on
the sale of shares will be taxed under the head of ‘income from other sources ‘ and will be
subjected to tax . As per the Income tax act premium paid by an investor in excess of the FMV
of the shares of the unlisted company will be taxable in the hands of company at a rate of 20%

It is agreed that angel tax came into being to protect india’s economy from Round tripping and
money laundering, but in a country like India which is still a developing country, entrepreneurs
and their start up are at stake at this point of time as companies which are unlisted and
unregistered will not be covered under ambit of DPIIT and for new startups most of their
investment is from foreign countries and because of this taxation series the investment will get
lowered leading to decreed in economy graph of india.

Hence, companies like Sequoia, Tiger Global, Blackstone would be levied a tax for investing
their money in Indian companies. The domestic citizens of India are already being taxed now
the NRI will get taxed too because of which there will be parity between the company and the
investor which will also cause delay in investment or no investment. Also apart from more than
FMV i.e the premium money investment is done more on rights provided to shareholder basis
ex. Voting, liquidating etc

Another problem which stands here is that angel tax falls under FEMA AND INCOME TAX
because of which its calculation will become more complicated and will lead to delay in growth
of startups in india. Investors from overseas already after too much thinking and pitching get
their money into small indian start up now because of tax they will back off.

The start ups wanted the Centre to take steps that will promote Indian start-ups. As of December
2022, there were over 1,800 funded start-ups in India and about 1,021 funding rounds closed
last year. As per a PwC report, funding for Indian start-ups in CY22 was nearly $24 billion, a
drop of 33% as compared to CY21. Only 21 start-ups attained unicorn status in 2022.

Startups are subject to severe limitations as a result of the angel tax exemption, including being
unable to offer salary advances, participate in stock M&A, establish a subsidiary, or render

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contributions to an ESOP trust. Due to the strict criteria, many entrepreneurs have abandoned
this exemption, and many are now looking to relocate abroad to circumvent these issues. 1

Approval must be taken from the Inter-Ministerial Board (IMB) for a startup to enjoy the
income tax benefits. The percentage of startups registered with DPIIT does not cross 1% of the
total startups in the country. Henceforth, this advantage can be enjoyed by only 1% of the
startups existing in the country.

It should be taken into account that CBDT, vide its announcement dated 13/2019, created an
exception for the investments startups obtain in exchange for shares if they are able to meet
some essential criterion. One of them is registration with DPIIT.

This exemption, in contrast to the tax holiday, is not subject to approval by the Inter-Ministerial
Board of Certification, which was established by the Department of Promotion of Industry and
Internal Trade. Only 1048 of the over 90,000 DPIIT-registered startups—or slightly more than
1% of the total base—have received board validation yet.2

This means that foreign investors would not be liable to pay angel tax on investments made in
startups that have been recognized by the government. However, this will have far-reaching
implications for the private startups that are not government-recognized. Foreign investors
would think twice before investing in such startups due to their liability for angel tax. But, there
are some exceptions to this taxation regime.

The startup's total paid-up share capital and share premium cannot go above INR 25 Cr. in
order to qualify for an exemption, though, once it has issued or intended to issue shares. As a
result, the Angel Tax was waived for local angel investors who normally make modest startup
investments. Since the major goal was round tripping the movement of money from and to
India, there was also an additional exemption for alternative investment funds (AIFs) listed
with SEBI and money obtained from foreign investors.

Does this mean this tax would only apply to offshore funds?

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https://www.livemint.com/companies/start-ups/how-angel-tax-continues-to-fail-startup-india-
11675787423658.html
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https://inc42.com/features/angel-tax-indian-startups-faqs-explainer/

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Yes, however this also comprises some of the biggest venture capital firms in India, among
them Y Combinator, AngelList, Tiger Global, Sequoia Capital, SoftBank, along with additional
unicorn producers.3

As of February 2023, there are 1052 investors in the exempted pool of AIFs, a majority of
which refrain from funding startups. According to assessments from AIFs, their percentage of
startup financing ranges from 10% to 15%, with certain ones even placing it under 10%.
Considering the complexity of startup fundraisers, it is frequently unclear what percentage of
the financial inflow a certain investor is exposed to, particularly given that every fundraising
effort usually includes several investors.

The amount of AIF investments compared to offshore funds or non-resident investors cannot
be tracked because company filings regarding money injections are frequently months behind
schedule, and even then, the actual money invested could vary from publicly available
assertion, as has been reported in the case of BYJU'S last year.

The newly planned Angel Tax is aiming to trace such activities, when Indian people are LPs in
blind pool foreign money, by eliminating the exclusion for offshore investments. While it can
request further information from AIFs regarding its investors, the Indian government does not
constantly have insight into the LPs that make up overseas funds.

According to a report from the previous year, SEBI had requested that AIFs reveal if the
financiers of their investments were domestic or foreign companies. Some investors contend
that the modifications suggested in the 2023 Finance Bill are an attempt by the government to
entice foreign investors to establish AIFs in India that fall within the purview of SEBI.

However, experts are of the view that FDI or capital flow limitations will have the opposite
effect on investment. Instead of starting AIFs with offices in India, international investors could
put pressure on Indian business owners and startups to do the same and relocate outside. In
hindsight, it will make it simpler for startups to choose the flipping route.

3
https://inc42.com/features/angel-tax-indian-startups-faqs-explainer/

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Industry experts have recommended a wide range of mechanisms to make sure that the decision
of the Central government to bring investments made by the foreign investors under the head
of angel tax does not hurt the startup funding. Some of the solutions include removing financial
institutions and investment players from the head of angel tax, in addition to investments made
by foreign firms, PE/VC funds and hedge funds.

The industry associations have also proactively proposed more stricter regulations to make it
more difficult for bad actors to take advantage of the exemptions given for startup investments.
These involve requiring startup securities to be maintained in dematerialized form and
prohibiting the transfer of shares for cash; instead, only checks, demand draughts, banking
channels, or other similar electronic mechanisms may be used to transfer shares.

Additionally, it is incorrect for the finance ministry's view to hold that only newly established
Indian businesses can access international investment. A large number of other private
businesses really use main infusion to obtain foreign investment as well. The issue of whether
or not issuing shares to linked firms would have transfer pricing ramifications could also come
up. It is important to keep in mind that the Bombay High Court determined that because the
issuance of shares is a capital account deal and does not result in any income, transfer pricing
regulations are not applicable to the issuance of shares. This decision was made in the case of
Vodafone India Services Private Limited (WP No. 1877 of 2013)

Issue of shares to non-resident investors and ‘Angel Tax’ applicability

According to statistics, India has the third-largest start-up ecosystem and is anticipated to
experience annual growth of 12-15%4. Our Prime Minister Shri Narendra Modi ji launched the
Make in India campaign in 2014 to aid and grow our nation by having more and more
entrepreneurs standing on their own two feet for betterment.

Given the size and enthusiasm of the entrepreneurial community for the start-up ecosystem,
and the fact that India is a growing nation, foreign investors play a significant part in that, the
government is exerting all of its influence to promote the start-up industry and has provided
numerous tax benefits over the years. According to the prior budget,

4
https://taxguru.in/income-tax/indian-start-ups-angel-tax-budget-2023-
impact.html#:~:text=However%2C%20as%20per%20specific%20a%20notification%2C%20eligible%20sta

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According to the Income Tax Act, the excess amount received over and above FMV is deemed
income of the firm, often known as "Angel Tax," when a closely held firm issues shares to a
resident investor above the fair market value (FMV) (computed in accordance with income tax
laws). However, qualifying start-ups are free from these "Angel Tax" requirements, and any
money received from resident investors over and above FMV is not counted as income,
according to a special notification. The budget for 2023 suggests that the above-mentioned
provision of taxability will apply to shares issued to non-resident investors over and above
FMV. Additionally, domestic investors in qualifying start-ups are free from the "Angel Tax,"
while non-resident investors are not.

As per section 56(2)(vii-b) of the income tax, 1961 that if an unlisted company issue share to
a person being the resident of india at a premium exceeding the face value and aggregate
consideration received from the resident if exceeds the fair market value than the exceed
amount of the share will be taxable under RULE 11UA(2) of the income tax rule , 1962 under
the “income from other sources “ head before the 2023 amendment

Given the market's volatility and the widely used methods of valuation, investors prefer to use
convertible instruments that can be converted into more equity shares. These instruments are
useful for valuation adjustments, anti-dilution measures, implementing liquidation preferences,
and agreed adjustments in the event of indemnity claims, among other things. In addition to
their investment decisions, investors also pay attention to the rights they currently have or will
have in the company. 5

Regulations governing foreign direct investment (FDI) provide that the conversion price of
convertible stock instruments in an Indian company cannot be less than the fair market value.
Non-residents frequently subscribe to these instruments at a premium price over the fair market
value in order to protect their economic interests. This premium price acts as a buffer for any
potential future conversion needed to protect their economic rights..

The Amended Section 56 has introduced a tax challenge for Indian companies that receive
investments from non-residents. Under the amended law, any difference between the issue

5
Trilegal-Update_Budget-2023_Angel-tax-on-share-consideration-received-from-non-resident-investors-1.pdf

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price of the shares subscribed by the non-resident and the fair market value (FMV) determined
under the Income Tax (IT) Act will be considered "income from other sources" and taxed
accordingly. This creates a discrepancy, as while the FMV requirement is prescribed under the
FDI norms, the applicable taxes under Section 56 are to be determined based on the IT Act
FMV. This means that the valuation must be undertaken using either the net asset, book value,
or discounted cash flow method and certified by a merchant banker. 6

Applicability under the FEMA Act

Foreign investments must be priced in accordance with the Foreign Exchange Management
(Non-Debt Instrument) Rules, 2019 and at or above FMV (as calculated by a merchant banker,
typically using the Discounted Cash Flow ('DCF') technique). 7

A systematic mechanism is provided by this Act for determining FMV by taking the help of
either the Net Asset Value (NAV) Approach, which mandates a requirement of certification of
valuation from a Chartered Accountant, or the Discounted Cash Flow (DCF) method, wherein
a merchant banker issues a certificate. According to FEMA regulations, equity instruments
issued to non-residents may not be offered for less than the value established using an
internationally recognised pricing technique.

Additionally, while the FEMA regulations lack explicit requirements, the Act does so in regard
to other components of the valuation report, such as the date of the balance sheet and the
valuation date. Even yet, it is standard practise for AD bankers to accept valuation certificates
that are no older than 90 days after the transaction date.

The fact that DCF is regarded as an internationally recognised pricing methodology was
adequate for a non-resident investor to meet the FEMA valuation standards. Non-resident
investors would nevertheless also need to make sure that the Act's FMV requirements are met
as a result of the proposed adjustment. In order to minimise any tax liability, taxpayers are

6
Applicability Of Angel Tax On Investments By Non-Residents To Impact India's FDI Dreams - Corporate and
Company Law - India (mondaq.com)
7
https://www.internationaltaxreview.com/article/2bjuhxdf1g65fgk7c10cg/sponsored/angel-tax-in-india-a-
retrograde-step-for-foreign-investment

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going to find it burdensome to make certain that the FMV value under both legislation is
consistent.8

But at this point, some subtlety needs to be taken into account. FEMA regulations do not
specify a particular value system, in contrast to tax standards. However, any internationally
recognised approach may be used to undertake valuation. Although this normally indicates the
DCF technique is contingent upon the business and operating structure of the PLC issuing the
shares, this might not constantly be the case. If the FMV required by FEMA regulations (FEMA
FMV) is calculated using a different approach than the DCF method, it will probably be
different from the FMV calculated for the intended use of the angel tax provision (tax FMV),
which is typically determined using the DCF method, as was mentioned above.

The equity shares can possibly be issued at a value ranging between the FEMA FMV and the
tax FMV in this scenario without violating tax or FEMA requirements, provided that the FEMA
FMV is lower than the tax FMV. However, because the FEMA FMV would be the issuance's
floor price and would surpass the tax FMV under the angel tax provision, it could not be
permissible for the PLC to issue equity shares if the FEMA FMV surpasses the tax FMV. 9

Applicability under the IT Act

The 2023 budget has brought about changes to the Income Tax Act's section 56, which has
been the subject of much controversy in the startup ecosystem. The tax in question, commonly
known as the "angel tax," applies to certain investors and seeks to tax share premiums by non-
residents while determining the cost of shares at fair market value.

The recently added clause 32 to the Financial Bill amends section 56(2)(viib) to regulate share
premiums and tax capital generated by a company through the sale of shares at a price higher
than fair market value. The primary objective of this tax is to discourage companies from
generating and utilizing unaccounted money by subscribing to shares of closely-held
companies at values higher than fair market value. 10

8
https://www.taxmann.com/budget/budget-story/510/expanding-the-horizon-of-angel-tax-on-investments-by-
non-residents
9
https://www.lexology.com/library/detail.aspx?g=f33a1fb8-628d-4792-9645-29798ea42dc6
10
Analysing the Impact of the Widening of Angel Tax on Indian Economy and Start-up Ecosystem (irccl.in)

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Previously, only residents were subject to this tax, but the recent amendment extends its
application to NRI/overseas investors in private companies. The aim is to deter the generation
and use of unaccounted money by companies through subscription of shares at values higher
than fair market value.

While the objective of the angel tax is to ensure transparency and prevent money laundering,
it has been a source of frustration for startups and investors alike. The amendment attempts to
balance the need for regulation with the need for a supportive environment for startups to thrive.

The conundrum between the two statutes

The IT Act and the FEMA's methods for computing FMV may not be entirely consistent, which
could make it difficult for taxpayers to comply with the law. In accordance with the IT Act,
taxpayers have the option of determining FMV using either the discounted cash flow approach
or the net asset value approach. However, the FEMA demands that value be done using any
well recognised price methodology.
Given that the FMV is frequently challenged by the tax authorities, the use of two valuation
systems is bound to result in disagreements. Additionally, one may anticipate more
disagreements on FMV being raised by the tax authorities by citing the valuation used for
FEMA reasons, and vice versa, as the data interaction between several Indian entities becomes
more smooth.11

Shares need to be offered to non-residents on an arrangement that is at least FMV compliant,

according to FEMA regulations. As a result, whereas FEMA regulations specify a floor price,
the angel tax clause specifies a ceiling value (above which the issuing PLC would face
unfavourable tax consequences). The FEMA pricing criteria and the angel tax clause seem
contradictory in this regard. In such a case, it appears that the PLC will have to issue shares
precisely the FMV, which can be quite limiting and might not be practicable from a business
perspective, in order to avoid implications under the angel tax clause or FEMA laws.

11
https://www.internationaltaxreview.com/article/2bjuhxdf1g65fgk7c10cg/sponsored/angel-tax-in-india-a-
retrograde-step-for-foreign-investment

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Such conflicts are on the rise due to the funds collected from non-resident investors being
brought under the scope of the provision. In addition, there are valuation-related problems
between the FEMA regulations and the angel tax provision, even though the premise of the
angel tax provisions applicable to conversion transactions is preserved. For instance, according
to FEMA rules, the conversion price of convertible securities cannot be less than the amount
paid by the non-resident investor at the time the securities were first offered for sale.

Converting instruments into equity shares might lead to a tax cost for the PLC under the angel
tax provision as a result of FEMA regulations stipulating the conversion cannot be done at a
price below the initial issue price. If the pre-negotiated conversion price is greater than the tax
FMV determined at the time of the conversion, comparable consequences may result.

CONCLUSION

In conclusion, the Angel Tax amendment in 2023 has brought some changes for startups
operating under section 56 of the Income Tax Act. These changes are likely to have a negative
impact on the new startups as they will find it challenging to attract overseas investments,
which will hamper their growth prospects. Private companies may also face difficulties in
raising funds, leading them to move their businesses overseas. Moreover, the two legislations,
FEMA and Income Tax Act, will create additional challenges in calculating the tax liabilities.
The government needs to take a more comprehensive approach to encourage startups and
ensure that they have a favorable environment to grow and flourish.

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