Looking a Gift Horse in the Mouth?

The decision of the Central Board of Direct Taxes (CBDT) to exempt investors from 21 nations from the “angel tax” ‒ a levy imposed on the capital raised by a startup since 2012 ‒ seems to have evoked strong feelings among the investor community, but some of them may just be looking a GIFT (read Gujarat International Finance Tec-City) horse in the mouth.  

The "angel tax," was originally introduced in 2012 as an amendment to the Income Tax Act Section 56 (2) (vii b) to discourage inflow of unaccounted funds into the country and prevent money laundering through the subscription of shares of a privately held company at a higher rate than the fair market value (FMV) of the firm's share. The tax was initially imposed only on domestic investors in startups, but the Union Budget for the 2023-23 fiscal now brings both foreign investors and non-resident Indian (NRI) investors within its ambit. 

The 26 May Union Finance Ministry notification now says that residents of 21 nations, including the United States, United Kingdom, Australia, Germany, Spain, Austria, Canada, the Czech Republic, Belgium, Denmark, Finland, Israel, Italy, Iceland, Japan, Korea, Russia, Norway, New Zealand, France and Sweden will be exempted from the angel tax. The notification seems to attempt to attract more foreign direct investments (FDI) into India from countries that have a strong, well-regulated framework. Financial sector experts point out that the notification aligns with the government's primary goal of restricting the flow of unreported funds or "black money" by bringing FDI within the purview of the angel tax.  

The decision is also being seen as an attempt to promote India’s very own tax haven ‒ the Gujarat International Finance Tec-City (GIFT) ‒ a smart city that lies between Gandhinagar and Ahmedabad. The GIFT City was formed under the Special Economic Zone Act, 2005 as India's first International Financial Services Centre (IFSC). The IFSC was declared a multi-service Special Economic Zone (SEZ) in 2015 to attract foreign investment and the Union Budget 2016-17 bestowed upon it a competitive tax regime. Since then it has indeed, evolved into a hub of banks, capital market entities, financial services and some captive manufacturing industries too. 

The 26 May notification of the Union finance ministry specifically excludes investments from tax havens around the world like Singapore, the Netherlands, Mauritius, Luxembourg and the UAE from the angel tax exemption. Other entities also excluded from the exemption include those registered with SEBI as Category-I FPI (foreign portfolio investors), Endowment Funds, Pension Funds, broad-based pooled investment vehicles with more than 50 investors and agencies with 75 per cent of government ownership.  

Obviously, the notification strives to attract more startups to the Gujarat International Finance Tech City, even those that had previously preferred tax havens like Mauritius and Singapore.  

Ironically, the tax havens excluded from the angel tax exemption, together account for over 50 per cent of the FDI into India ‒ and thereby hangs a tale.  

Department for Promotion of Industry and Internal Trade (DPIIT) data shows that Singapore was the top investor during the 2022-23 financial year with USD 17.2 billion having come into India in the way of FDI, followed by Mauritius (USD 6.13 billion), the United States (USD 6 billion), the United Arab Emirates (USD 3.35 billion) and the Netherlands (USD 2.5 billion). Note that the US is the only destination in this list that is not a tax haven. The total FDI inflows (comprising equity inflows, reinvested earnings and other capital) fell by 16 per cent in the fiscal gone by to USD 70.97 billion from USD 84.83 billion in the 2021-22 financial year.

Startup Funding 

Many financial market experts feel that the government’s attempt to close tax haven loopholes for investments may actually boomerang on funding for startups. The exclusion of tax-friendly countries from the angel tax exemption may have a huge negative impact on raising capital, say the knowledgeable in the financial sector.  

"Investors choose these jurisdictions for ease of business, certainty of laws, consolidated offices and management, etc. The government should focus on ensuring compliance and KYC of our laws, not cherry-picking like this. Investors should have the choice of location from which they invest so long as they pay any taxes in India, comply with KYC, etc. There is no reason why you give exemption from angel tax for investment from the UK but not from Singapore, even for the same investor," says Mohandas Pai, Chairman at Aarin Capital. 

Others feel that there was a high possibility of startups (that now draw investment from the international tax havens) shifting their locations to new geographies to bypass the angel tax. Moreover, it would eventually push fewer startups into the unicorn club. "There could be an impact on the speed of creation of unicorns as the funds that currently come only through these geographies may be impacted by angel tax issues," explains Vikram Gupta, Founder and Managing Partner, IvyCap Ventures.

GIFT And The Tax Havens  

Going by Department for Promotion of Industry and Internal Trade data, Singapore received USD 13.08 billion in FDI between April and December 2022, while Mauritius received USD 4.73 billion. The amount invested in securities that do not attract the angel tax is also included in the FDI inflow data. 

"The specific exclusion of tax havens from the list may potentially compel foreign investors to alter their valuations to avoid tax, regardless of justifiable grounds for a valuation premium. The exemption of tax-friendly countries may force early-stage startups to move out of India,” cautions Gupta. He feels that investors may insist on startups changing their holding structures. “However, changing holding structures at the late stage of a company is expensive and may not align with all the shareholders of the company,” he points out. 

"There have been increased efforts to promote investments through the GIFT city. Going forward, we will see more and more investors coming from other geographies but using Mauritius, Singapore, Ireland, the Netherlands, Luxembourg to come via the GIFT City if they want to not be impacted by Angel Tax issues," Gupta goes on to say. 

Pai emphasises that "GIFT needs marketing to become more popular, not any short cuts like this. This will not work if the government thinks shutting out Singapore will make GIFT more popular. GIFT will grow on its own good policies, not changes like this. GIFT is fast-growing and does not need crutches but good policy." 

Reality Check

Interestingly, according to experts, the number of firms actually qualified to receive the angle tax exemption could be below five per cent of Indian startups registered with the Department for Promotion of Industry and Internal Trade. A formal notification specifying the five criteria for valuation recommendations submitted by stakeholders is, however, yet to be issued.  

The lengthy list of criteria that needs to be met over a seven-year period usually deprives most startups of tax sops, in any case. At the end of the day, laments the startup community, what investors are grappling with are not policy announcements, but their implementation. The time lag between a proposal and its implementation sets back investors and before they know it, an opportunity is lost. The consensus is that the need of the hour, is strong and swift implementation of policies rather than mere announcements.