Foreign funding in local startups is now subject to an ‘owner tax’

Indian startups that raise capital from foreign investors such as Sequoia Capital, SoftBank, Prosus, Tiger Global, Carlyle, KKR and Blackstone will now have to pay an ‘owner tax’, a move that may not only negatively affect financing but also More startups to locate abroad.

Announcing the federation’s budget on Tuesday, the finance minister said non-residents would now come under the authority of Section 56(2) VII B, better known as the ‘landlord tax’, which was introduced in 2012 as an anti-abuse measure. It was intended for tax evasion.

However, alternative investment funds registered with the Securities and Exchange Commission of India (SEBI), the market regulator of India (SEBI), are still exempt from the angel tax.

This is likely to be a challenge for startups already experiencing a global funding crisis, as the bulk of the capital raised comes from foreign investors. In 2022, private equity and venture capital financing in India reached $54 billion, while it was close to $77 billion in 2021, a record year for Indian companies.

“Non-resident investors were not subject to the scope of this tax,” said Ritesh Kumar, partner at J Sagar & Associates. “We all hope this is a mistake,” he added.

An angel tax is applied if the share price allocated to the investors is higher than the fair market value (FMV) of the share. In that case, the difference is subject to Section 56(2) VIIB. For example, if the fair market value (for a par value share of Re 1) is Rs 10 per lot, and if the startup allocates a share at a premium of Rs 15, then the difference of Rs 5 will be taxed as income at startup.

Theoretically, this is likely to be more severe in the case of early-growth startups – where the divergence is higher between the FMV and the allocated share price. This difference is usually less severe in mature companies.

Until now, start-ups raising foreign capital were outside the scope of taxation as long as shares were issued in accordance with the RBI pricing guidelines on share premium. This suggests that any amount received by a closely owned company be included in net tax (including startups). It did not qualify as investment capital that pledges to receive an investment from a venture capital fund) from a non-resident person in return for a subscription to shares where the consideration is “higher than the fair market value”.

This could force more startups to move abroad, as foreign investors may not want to deal with additional tax liabilities by virtue of their investment in the startup, according to Siddarth Pai, founding partner of VC firm 3one4 Capital. “Reintroduction is completely counterintuitive to the entire reverse flop action. This will, in fact, speed up the outside flop,” Pai added.

“The angel tax has been the sword of Damocles hanging over the heads of many Indian startups. This has been misapplied to them because all startups end up collecting money from investors at a premium, and often the tax demand comes after a year or a year and a half. No investor will touch this. startups because whatever money they put into the startup will actually go toward clearing old tax liabilities.” He added that startups will be taxed under “income from other sources” and the corporate tax rate will be applied.

This will also apply to domestic investors who are not registered with AIFs in Sebi. “If the money comes from hypothetically from the State Bank of India or LIC to a startup, that will also be taxable because they are not Sebi registered AIFs,” Pai added.

To avoid the scope of the landlord tax, startups can file a Form 2 Exemption. However, as per the law, this exemption will prevent the startup from several activities such as not setting up a subsidiary, and not making any advance payments on salary, rental deposits or vendor advances. Startups also can’t make treasury investments or participate in equity mergers and acquisitions—claiming that exemption would hinder the startup in many ways, according to Pai.