Foreign Investment in Indian Start-Ups
By Anjali Kukreja and Raghu Marwah, R.N. MARWAH & CO. LLP
Foreign investment in Indian startups, especially in high technology areas of artificial intelligence and consumer-facing apps, offer a big opportunity. The start-up space in India offers a win-win scenario for all, as foreign investors multiply their investment values with high IRR’s and Indian start-ups provide increased jobs, digitalised lifestyle and improved product innovations contributing to a more vibrant and rewarding economy, as well as a positive social impact.
Indian start-ups attract Non- Resident High Net Worth Individuals (NR-HNWI) and Family Offces, who have funded a big chunk out of $38.3 billion(1) across 1000 deals garnered by Indian Start-Ups in 2018.
It has been seen in the recent past that Non-Resident High Net Worth business families are very promising supporters of the Indian start-ups. These families often come with deep domain business expertise in the field of the Indian start-ups they choose to fund and do not have a fixed exit timeframe as stringent as that of venture capitalists, funds and other investors. It has often resulted in making these Non- Resident HNWI/business families become the owners of prominent profitable Indian start-up ventures (often considered risky in its early stage). Various investment options available to the Non-Resident HNWI and business families are enumerated in the ensuing paragraphs below.
Purchase of shares/debentures in Indian Start-up Companies
NR-HNWI/business families can invest directly by subscribing to shares (equity or compulsorily convertible preference shares) or debentures of these Indian start-up companies. During the tenure of these investments, NR-HNWI investor would continue to receive income in the form of dividends or interest. Dividends paid by Indian companies are subjected to Dividend Distribution Tax (DDT) under section 115-O of the Indian Income Tax Act, 1961(ITA) at the company level and are tax-free in the hands of the shareholder recipient. No credit of DDT would be available to NR-HNWI. Interest would be taxed under Indian tax laws as per the individual slab rate applicable to NR-HNWI, however, subject to relevant tax treaty relief.
On exit, i.e. on the sale of these shares, controlling rights of the Indian start-up company, NR-HNWI would be liable to pay capital gain tax as per Indian domestic tax laws subject to the relevant tax treaty benefit. As per Indian tax laws, the rate of capital gain tax in India is determined on the basis of the period of holding. In case the period of holding is more than 36 months (assuming shares of Indian start-ups are unlisted), gains are taxed as long-term capital gains at the rate of 10% (plus applicable surcharge and cess) without benefit of foreign currency conversion or cost indexation under section 112(1)(c) of ITA. Capital receipts would be received by NR-HNWI (net of tax). Further, NR-HNWI would be required to obtain PAN and file its Indian Income Tax Return in respect of the transaction.
Capital contribution in Indian Start-Up LLP
NR-HNWI can also invest in Indian Start-up Limited Liability Partnerships (LLP) by way of capital contribution as partners. Income earned by Indian Start-up LLP would be taxed in the hands of LLP at the rate of 30% (plus applicable surcharge and cess). Any drawings by NR-HNWI partners would be tax-free. In case of a change in the shareholding of Indian Startup LLP, there may be no exit tax in the hands of the outgoing partner.
Investment through Funds
NR-HNWI can incorporate Alternate Investment Funds (AIFs) registered with the Securities Exchange Board of India (SEBI) (in form of company, trust, LLP or body corporate) for investment in eligible start-ups. Taxation of AIFs is briefly explained below:
- AIF registered as subcategory I of category I AIF enjoys pass-through status. That is, any income earned by these funds are tax exempt in the hands of the fund under section 10(23FB) and are taxable in the hands of NR-HNWI investors under section 115U of the Act. No dividend distribution tax or withholding tax would be applicable on payment of income by the AIF to its NR-HNWI investors.
- Other AIF registered as Category I and II (also known as Investment funds) enjoy pass-through status for incomes other than business income. That is, business income would be taxable in hands of AIF under section 115UB, and its distribution would be tax-free in the hands of NR-HNWI investor. All other income (other than business income) would be exempt under section 10(23FBA) in the hands of the AIF and hence, taxable in the hands of NR-HNWI. No dividend distribution tax would be applicable on payment of income by the AIF to its NR-HNWI investors.
- Income from AIF Category III does not enjoy pass-through status. Income would be taxed at the applicable rates to the entity. For instance, if AIF is incorporated in the form of a business trust, its taxation would be governed by the income tax provisions as applicable to the business trusts. Dividend distribution tax or withholding tax as per ITA to be applicable on payment of income by this AIF to its NR-HNWI investors.
In all above AIFs, the investor can exit at any time by transferring its units of AIF on payment of tax on the capital gain component of consideration received on sale of these units, subject to relevant tax treaty relief.
NR-HNWI investors are entitled to claim taxability of income from AIFs during investment tenure as well as on exit under the relevant tax treaty of India if it is more favourable to it than the ITA provisions.
Investments through Business Trusts
NR-HNWI can set up Business Trusts that in turn invest in an eligible start-up company. On the taxation front, any income comprising of interest and dividend is exempt under section 10(23FC) in the hands of the trust but is taxable in the hands of the investor as per applicable tax rates. Income comprising of capital gains, business income, or other source income to be taxed in the hands of the business trust in accordance with section 115UA of the ITA and hence, is tax-free on its distribution to the NR-HNWI unitholders. Further, in case of transfer of units of business trust by the NR- HNWI unitholders, tax would become payable by the unit-holders on the capital gain component earned by them subject to the relevant tax treaty relief.
Investment in Indian start-ups is a high risk and reward activity. The investments are often made by NR-HNWI and business families to reap high returns. As an investor, there is always a choice whether to get involved in the day-to-day management of the start-up business or to let the concept owner take care of it. Considering the ease of entry, exit, clear Indian tax laws, availability of relevant tax treaty benefits, investments in Indian start-ups are very promising and lucrative to the Non-Resident, as well as Resident, High Net Worth individuals and business families.
Raghu MarwahR.N. Marwah & Co LLP, Bangalore, New Delhi, India
T: +91 114 319 20 00
Anjali KukrejaR.N. Marwah & Co LLP, Bangalore, New Delhi, India
T: +91 114 319 20 00
The Authors are expert in the field of International Tax and specialize in family office advisory, especially targeted towards India-UK Investments.
Published: GGI Insider, No. 100, March 2019 l Photo: StockImageFactory - stock.adobe.com