Foreign investments are the lifeblood of Indian startups, but the newest financial legislation could challenge the vitality of this ecosystem.

In the unfolding narrative of India’s bustling startup landscape, the Finance Act of 2023 recently cast a long shadow. By extending the contentious angel tax to foreign investments, a bureaucracy appears to have tightened its grip, causing trepidation among Indian entrepreneurs. It’s particularly significant given that these foreign investments comprise over 90% of the private capital that startups rely on.

Historically, the angel tax—incorporated into Section 56(2) of the Income Tax Act of 1961 via the Finance Act of 2012—was imposed on the overvaluation of shares during early funding rounds of a startup. Specifically, it targets shares issued at prices above their audited fair market value. The result? Such capital gets added to a startup’s total income and is taxed at a hefty 30.6%. Designed to prevent fund misuse and favor genuine startups, the tax often seems more inhibitive than protective.

Indeed, while this measure was conceived to mitigate the potential misappropriation of funds, taxing early-stage startups on share premiums has inadvertently stifled their growth. The government’s move feels paradoxical, especially when juxtaposed against India’s broader ambition: to create a thriving environment for nascent businesses. Moreover, the decision to expand the angel tax’s purview—effective from the assessment year 2024-2025—is not without complications. Key among them is the omission of “being a resident” from Section 56(2).

Previously, a gamut of non-resident investors, from foreign banks to entities registered with the Securities and Exchange Board of India (SEBI), enjoyed exemptions from the angel tax. Now, this privilege is limited to ‘notified entities’ from a specific set of 21 nations, including the United States, Japan, and Germany. Startlingly absent from this list are vital investment sources like Singapore, the UAE, and the Netherlands. These nations, known for their regulatory allure, contribute over half of India’s foreign direct investment. Their exclusion could signal a shift in India’s investment strategy.

Such a move could provoke investors to reconsider and restructure their commitments, potentially leaning into instruments like convertible debts to sidestep these new tax ramifications. Although these jurisdictions, with their favorable regulatory regimes, might still be the go-to for investors, India’s position might weaken in the long game.

Furthermore, there’s an inherent incongruity in levying income tax on capital raised, when logically, it should be applied to business profits. The method of calculating the fair market value of shares for budding ventures often defies conventional wisdom. Given today’s sophisticated startup ecosystem and ample means to monitor questionable transactions, alternatives to the angel tax—like investor registration and fund ownership disclosure—seem more fitting.

The debate around the angel tax has also been marred by ambiguities regarding its effective date. Thankfully, the Finance Bill’s accompanying memorandum clarifies that the provision will apply from the financial year 2023-24, not the assessment year beginning in April 2024.

Another phenomenon drawing scrutiny is “reverse-flipping”—where foreign entities acquire Indian startups, capitalizing on tax benefits abroad. As the modified angel tax largely applies to resident investments, will this encourage more reverse-flipping? While the implications are manifold and multifaceted, startups and investors alike must tread cautiously.

The expanding reach of the angel tax is more than a fiscal matter; it’s emblematic of the challenges facing India’s fragile startup world. Even as India’s bureaucratic measures might be more formidable than in many developed nations, this move risks constraining innovation. The recent Finance Bill’s passage, sans any investor-friendly relaxations, was a missed opportunity, although some consolation lies in the Ministry of Finance’s assurances to address stakeholders’ concerns.

In an interesting twist, the policy hasn’t been universally panned. There are commendable attempts to refine the oversight of previous angel tax provisions. With startups now required to procure a certification from the Income Tax Authorities (ITA) before engaging with non-resident investors, there’s a renewed focus on ensuring the legitimacy of investments. ITA’s bolstered powers—inspections, seizing of documents, and summoning witnesses—signal a more vigilant era. Coupled with stiffer penalties and provisions like ‘safe harbor’ and ‘price matching,’ there’s a semblance of a silver lining.

Despite its well-intentioned roots, the angel tax’s implementation leaves room for apprehension among startups and investors. A holistic appraisal is needed to gauge if the policy’s drawbacks eclipse its intended benefits. As India aims to nurture its entrepreneurial spirit, it’s paramount that it creates a climate conducive to investment and innovation, rather than saddling it with burdensome taxes.