The Need to Remove Angel Tax (3one4 Capital)

Summary

• Section 56(2)(viib) was inserted in 2012 and has been applied to startups since 2016.p.2
• It was extended to non-residents from FY 2023-24 onwards.p.2
• The DPIIT circular exempts registered startups from angel tax up to capital raises of INR 25 Cr.p.9
• Industry estimates place foreign capital at 85% of total investments into Indian startups.p.13
• Since the extension to non-residents, startup funding has dipped 62% YoY, the lowest amount raised in 6 years.p.13
• Of the top 5 FDI source countries, 3 are not part of the 21 countries in the Safe Harbour list.p.12

Key insights

1. Section 56(2)(viib) applies to unlisted companies issuing securities at a premium above fair market value, with the difference taxed in the company's hands.p.2
2. A high share premium results from legitimate business decisions such as a low number of securities issued, low face value and investor valuation.p.3
3. Losses are a norm and not an exception for startups, reflecting investment in the business rather than lack of value creation.p.5
4. The main enforcement issue is tax officers comparing a company's projections with its actual performance and disregarding the valuation report.p.6
5. The US Internal Revenue Code (IRC 1032) states that an exchange of stock for cash is not treated as income.p.8
6. A variation of 10% between fair market value and issue price is acceptable for non-resident investments.p.11
7. Mandatory dematerialisation by September 30, 2024 reduces the transparency gap between listed and unlisted companies.p.14
8. The paper concludes that Section 56(2)(viib) has no parallel in the global economy and should be removed.p.17