India’s Budget 2023: Impact on Venture Capital and Private Equity Investment

The Indian Government was expected to come up with promotional policies and reforms to improve the venture capital India ecosystem and scale up Private Equity (PE) and Venture Capital investments in India. Investment and the Financial sector are two of the seven priorities of the Indian Government as mentioned by the Finance Minister Mrs Nirmala Sitharaman in India’s Budget for 2023-24. These priorities are the blueprint for an empowered and inclusive economy, making Venture capitalists and other investors optimistic. Even though there is still regulatory uncertainty and complexities surrounding investment modes and models, it is evident that the budgetary provisions would enable the growth of venture capital in India.

It was widely expected that some policy interventions to break the barriers pertaining to regulations. But misses in the budget are more dominating than hits. The policy interventions were expected in areas of taxation of ‘carried interest’, Long Term Capital Gain (LTCG), foreign pricing rules and co-investment framework, use of convertible instruments, absence of hedging and leveraging options, and downside protections. Reforms in these areas are the much-awaited expectations of the industry. Over the years venture capital market size in India has grown significantly and tax reforms and other regularity clarity would have pushed the investment in 2023. Private equity and venture capital investments in India totalled $54 billion in 2022, compared to a record-breaking $77 billion in 2021 for Indian companies. However, the venture capital fraternity is hopeful that before finalizing the Budget, the Indian government may consider rationalization of capital gains tax to boost capital inflow. ‘Carried interest,’ which is the share of profit for VC through fund management, is taxed both under direct (Income Tax and indirect tax (GST). A tax parity on the capital gain between listed and unlisted shares would have a game changer.

The Importance of Investors

(PE and Venture Capital investors have significantly contributed to creating a robust startup ecosystem in India)

The Indian government needs to acknowledge the importance of PE and VC investors and with a rational policy, it can increase the flow of capital to startups and accelerate the velocity of the startup revolution. Hopefully, the Indian government would come up with promotional policies and reforms, while finalizing the Budget 2023-24, to improve the venture capital ecosystem and scale up PE/VC investments in India. Foreign venture capitalists and other investors significantly contributed to enhancing the venture capital market size and the growth of venture capital in India which in turn created a robust startup ecosystem. Foreign investors were never under the gambit of the angel tax and they would surely expect a more rational policy on this.

The Return of Angel Tax

(The return of Angel Tax may adversely affect the startup funding in India, especially at the growth stage)

Now, the government (Union Budget 2023-24) has announced bringing foreign investors under the angel tax gambit. After nearly a decade Angel tax has returned on foreign investors. This would have a wider implication for the growth of venture capital in India. Foreign investors including Non-Resident Indians (NRIs) will now come under the purview of Section 56(2) VII B, also known as the angel tax. As an anti-tax evasion or avoidance measure, the angel tax was brought in 2012. Indian startups raising capital from foreign investors and venture capital firms such as SoftBank, Sequoia Capital, Prosus, Tiger Global, KKR, Blackstone and big venture capitalists will now have to pay angel tax. The budgetary move has the potential to squeeze into the startup sector and prompt more startups to shift overseas.

Some may see the return of angel tax as an attempt to level the playing field for domestic investors that was tilted in favor of foreign entities. The Securities and Exchange Board of India (SEBI) has continued to exempt alternative investment funds (AIFs) from paying taxes. Previously foreign investors were exempt from any sort of angel tax and that was instrumental in driving the growth of venture capital in India. Indian startup ecosystem got tremendous support from foreign investors and the majority of the funding came from them. The return of angel tax would certainly have an adverse effect on startup funding- growth-stage and even beyond.

It is easy to understand when and how an angel tax is imposed. It is imposed when the share price, allocated to investors, is more than the share's fair market value (FMV). For example, if the startup allots a share at a premium of Rs 15, and the FMV (of a Rs 1 face value share) is Rs 10, then the difference of Rs 5 would be taxed as income at the startup's expense.

The Road Ahead

(No one like additional tax liability. Hence foreign investors may refrain from additional tax liability by virtue of their investment in the startup)

The impact is likely to be more severe for early to growth-stage startups – where the divergence is higher between FMV and the price of the share allotted. The government’s decision proposes to bring into the tax net any amount received by a startup or closely-held company from a foreign venture capital towards subscription of shares with higher market value. India needs to bring in foreign investment, hence its policy should not compel startups to flip overseas, and foreign investors may not want to deal with additional tax liability due to startup funding.

Has angel tax been misapplied to non-resident Indians or foreign investors? Startups may think that they would end up raising money from venture capitalists or angel investors at a premium and it is most likely that the tax demand would come after a year or beyond. In such a situation, investors would refrain to invest in startups only because they will logically think that any funds they infuse may actually go toward settling previous tax liability as well.

It is also a pain point that angel tax would be taxed for startups under “income from other sources" and corporate tax rates would apply. The flaws need to be corrected as Angel Tax may affect big domestic investors such as Life Insurance Corporation (LIC) and State Bank of India (SBI), in case they decide to invest in startups, as they are not Sebi-registered Alternate Investment Funds (AIFs).

Notwithstanding, the impact of angel tax, venture capital and PE investors would see a lot of changes and find that India is also moving towards ease of investment. A Single Window System to address the issues of the investment sector is expected to be taken by the government.

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