India’s angel tax rules may hit investor confidence

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India has amended its angel tax rules, expanding its reach to a large number of investors. These changes will impact the infusion of fresh capital by corporate entities with closely held subsidiaries in India. However, investors such as pension and sovereign wealth funds from 21 countries are exempt from these new regulations. This policy shift comes at a time when India aims to enhance the ease of doing business and attract foreign direct investments (FDI).

The income tax authorities have issued notices to several MNCs to scrutinize their funding. The government has decided to include multinationals from the US, UK, and France in the scope of angel tax. Consequently, when the Indian subsidiaries of these MNCs bring in new equity capital, they will be subjected to tax provisions. The potential inclusion of foreign multinationals in angel tax scrutiny could have repercussions for FDI inflows.

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Unfortunately, the timing of this move couldn’t be worse, as FDI into the country is already slowing down. The latest available figures show a 16% decline in FDI during FY23, following years of growth. FDI now stands at $71 billion (gross basis) for 2022-23, primarily due to global factors, marking the first decline in a decade.

This change also raises concerns about India’s attractiveness as an investment destination. Previously, the government granted a blanket exemption from angel tax to various structures, including pension and sovereign wealth funds, investing in India from 21 countries. However, corporate entities were excluded, potentially making them liable to pay the levy.

The recent alteration to the income tax regime, without any specific carveout for corporate overseas investment in unlisted subsidiaries, will only result in increased tax queries and undermine the ease of doing business in the country. Multinational corporations play a vital role in driving FDI, bringing capital, technology, and expertise. However, analysts believe that subjecting these corporations to angel tax scrutiny will impose additional compliance burdens and uncertainty, thereby reducing business confidence in India. The decline in FDI inflows will also have a negative impact on economic growth and development.

What is angel tax?

Angel tax is imposed on capital raised by unlisted companies, earning its name due to its severe impact on investments made by angel investors. This tax provision was introduced in the Finance Act of 2012 and came into force in April 2013. As per Section 56(2)(viib) of the Income-tax Act, 1961, unlisted companies receiving consideration exceeding the fair market value for shares issued to Indian residents are liable to pay income tax on the excess consideration. Angel tax was introduced to combat money laundering and prevent the misuse of funds through undervalued share issuances.

The introduction of this section aimed to discourage companies from generating and utilizing unaccounted money by subscribing to shares of closely held companies at values higher than the fair market value. The government recently made changes to the angel tax provisions in the latest Union Budget. Previously, these provisions only applied to investments received from resident investors. However, they have now been extended to non-resident investors as well. Consequently, any premium received by an unlisted company for issuing shares to non-residents would also be subject to taxation.

Furthermore, the government has exempted investors from 21 countries from the angel tax levy for their investments in unlisted Indian startups. These countries include the United States, the United Kingdom, France, Australia, and Japan. The notification also mentions other nations such as Austria, Canada, the Czech Republic, Belgium, Denmark, Finland, Israel, Italy, Iceland, Korea, Russia, Norway, New Zealand, and Sweden.

However, countries like Singapore, the Netherlands, and Mauritius, which constitute a major portion of foreign direct investment in India, have not been included in the exemption list. This decision aims to address loopholes resulting from investments made through tax havens. Nonetheless, experts believe that the exclusion of these countries will impact startup fundraising, as they are significant sources of investment for them.

While the aforementioned policy change sought to create a more favourable environment for foreign investments, subjecting foreign multinationals to angel tax scrutiny in recent times erodes investor confidence and discourages foreign investment, resulting in policy ambivalence.

Policymakers must now prioritize creating a stable environment for foreign companies to attract and retain global investments. There is a need for a clear and consistent policy framework to prevent the perception of instability and unpredictability among investors.