After the angel-tax repeal: what's still unresolved for early-stage fundraising in India

The Union Budget 2024's removal of Section 56(2)(viib) - the provision that imposed income tax on the difference between the fair-market value and the issue price of shares in unlisted companies, colloquially known as angel tax - was greeted with genuine relief by the startup ecosystem. The provision had been a source of friction, anxiety and occasionally existential threat for early-stage companies for nearly a decade, with the income tax department's valuation assessments routinely differing from the investor-agreed prices in early funding rounds and triggering demands that startup founders were often unable to pay. The repeal eliminates the angel-tax risk on new investments, which means term sheets from 2024 onwards no longer need to include the complex valuation-defence provisions, prescribed valuation methodologies and risk-allocation clauses that had become standard in India-focused early-stage term sheets. For foreign investors in particular - who were made subject to the provision through a 2023 amendment - the repeal removes a deterrent that had caused some overseas venture funds to route their Indian investments through Mauritius or Singapore holding structures to avoid potential Indian tax exposure on notional gains. What remains unresolved is the legacy of the pre-repeal era. Companies that received angel-tax assessments before the repeal remain in various stages of dispute resolution, with the Income Tax department having issued demands that were either contested in tribunal proceedings or settled. The Finance Ministry has indicated some intent to address legacy cases, but the specific mechanism and scope of relief has not been clearly articulated as of the time of writing. Companies that paid tax under the provision and those that are still in appeal face different circumstances, and the resolution of this backlog will require specific administrative action rather than the automatic forward-looking relief that the Budget provided. Other outstanding friction points for early-stage fundraising include ESOP taxation - Indian employees are taxed on the spread between exercise price and fair-market value at the time of exercise rather than at the time of sale, creating a cash-flow problem for employees who exercise options in private companies that do not have liquid secondary markets. Transfer-pricing scrutiny of transactions between related entities across different company structures remains a concern, particularly for startups with Indian operating entities and Singapore or US holding companies. And the basic question of how valuations are determined for unlisted shares - a question that angel tax required to be answered formally - has not been replaced by a clearer framework, merely by the absence of a tax consequence. What to watch: whether the Finance Ministry releases specific guidance on legacy angel-tax case resolution, whether the ESOP taxation reform that the startup ecosystem has lobbied for since at least 2019 makes progress in subsequent budgets, and how the angel-tax repeal affects the volume and structure of seed-stage investments in the 2024-2026 period relative to the preceding three years.

Original source: Entrackr