High net-worth individuals have a greater incentive to invest in Indian startups now

• On May 24th, the Central Board of Direct Taxes granted angel investors a complete tax exemption on their equity investments in small startups.
  
• Until now, a tax of 30% was levied on the amount that the shares issued by startups to investors exceeded their fair value.
  
• The ruling is expected to encourage high-net-worth individuals and give a significant boost to the startup funding landscape in India.
  
  

A ruling by India’s Central Board of Direct Taxes (CBDT) just made it easier for high-net-worth individuals to invest in startups. On May 24th, the CBDT granted angel investors a complete tax exemption on their equity investments in small startups, above their fair value. The move has been made effective retroactively from April 11th this year.

Until now, a tax of 30% was levied on the the value of shares issued above their fair value, by startups to investors, based on the budget released by former finance minister Pranab Mukherjee in 2012. This was done to prevent money laundering and selling of shares at a higher value than they were worth for the purpose of bribery.

However, this discouraged angel investors from buying shares at a premium, unlike venture capital funds and foreign investors, which benefited from a tax exemption for the same transaction. The premium received by these startups from angel investors for their equity was oddly classified as “income from other sources” and taxed accordingly. Hence, a lot of startups weren’t able to get the funding they needed in order to grow and compete for investments from VCs.

As a result of the ruling, angel investors will be given the same treatment, for tax purposes, as venture capital funds. This is expected to incentivise high-net-worth individuals and give a significant boost to the startup funding landscape in India.

Fair value?

The major issue of contention here related to the “fair value” of a startup - which fails to take into account intangible assets like goodwill or brand buzz - leaving them vulnerable to higher taxes on their angel investments if authorities feel the investment is well above what their valuation should be. If startups aren’t incentivised to sell their shares at a price above their fair value, their valuation will remain the same, regardless of their progress.

The CBDT’s notification also included a change in the entity responsible for assessing the fair value of startups. From now on, only merchant banks, as opposed to chartered accountants, are allowed to determine the value of an enterprise.

Strings attached

There are some conditions to the tax exemption, however. Firstly, it only applies to startups with a paid-up capital of ₹100 million or less following the share issue. So this covers the bulk of early-stage startups, which still bodes well for India’s startup ecosystem. Secondly, to qualify as an “angel investor”, an individual needs to have a minimum net worth of ₹20 million or an average income of ₹2.5 million in the previous three years.

Thirdly, the startup will have to procure a certificate indicating the fair value of the shares from a merchant banker.

While the cost of obtaining the certificate from a merchant banker is definitely higher than getting a chartered accountant to sign off on a startup’s fair value, the greater flow of financing will likely make up for this.