Angel Tax and Start-Ups in India

♦ Introduction

India is a country of many great legends who were famous all over the world because of their works, sharp mind and high skill. However, our country is still on the developing track because of the lack of some solid support and ways to work in right direction. Youths in India are very talented, highly skilled and full of innovative ideas. The initiatives is necessity to lead India in right direction. The most important point is that it involves youths of the country as start-ups as they have fresh mind, innovative ideas, required strength, energy, skill, and new thinking to lead business. Developing Start-up is an timeless phenomenon. At the core of it lies one’s basic desire to create a product or service which serves a greater purpose, and make your own niche in the process. As start-ups turn out to be a major source of revenue and employment, governments from across the world have been going out of their way to facilitate the entrepreneurial dream. Even India has done its fair bit to support start up dreams by means of its flagship ‘Make in India’ programme and a plethora of other schemes like ‘Start up India’. But even with all these schemes and options, one thing that is still a potential cause of worry is the so-called angel tax.

♦ History of Angel Tax In India

The tax was introduced in the 2012 Union Budget by then finance minister Pranab Mukherjee to arrest and stop laundering of funds. It has come to be called angel tax since it largely impacts angel investors in start-ups.

♦ Law Governing Angel Tax In India

Section 56(2)(viib) of  Income Tax Act, 1961 is the core section of Angel Taxation. Angel taxation is only an terminology given to tax levy under the abovementioned section.

• Detailed Analysis of Taxability of Angel Tax.
• when a closely held company issues equity shares and
• any investor subscribes for such shares and
• pays such consideration per share which is above the fair value of such shares, then such excess i.e. (Consideration per share less Fair Value per Share) is to be treated as income from other sources of such receiver company and Consequently such company has to pay tax on such excess amount @ 30% plus cess as applicable.
• When this section becomes applicable to a closely held company and such company is a startup company, then tax paid on such excess receipts(amount above Fair Value)  is termed as Angel Taxand Similarly the persons investing in its shares are termed as Angel Investors.

♦ Point of Concern:. 

• The main point of Concern is Fair Value of Investments as per Rules Specified By Income Tax and Fair Value Generally Accepted for Valuation of Start up for Investment by Angel Investors. In the current pace of start-ups and investments and taking consideration into the Rules prescribed by Income Tax Act the valuation of start ups has to be greater than the value derived by Income Tax Rules and the angel tax is nothing but an Tax on difference between (Value of share for Investing in start-ups and Fair Value as per Rules given by Income Tax)
• Fair Value As Per Income Tax Rules. (Rule 11U And 11UA)
  • Rule 11Uof the income tax rules provides for the meaning of expressions used in determination of fair market value while following methods prescribed under Rule 11UA of the income tax rules.
  • Rule 11UA, on the other hand, provides for methods of determining fair market value of a property, other than immovable property, including valuation of :-
    • Jewellery,
    • Archaeological collections, drawings, paintings, sculptures or any work of art,
    • Shares and securities (both quoted and unquoted)
• Fair Value Generally Accepted for Valuation of Start up for Investment by Angel Investors.
  • Valuation of start-ups is also a different world since industry demands Discounted cash flow (DCF) method to be applied instead of Net Assets Value (NAV) method. The valuation of a start-up is usually based on a commercial negotiation between the company and the investor, and it depends on the company’s projected earnings at that point in time. However, since start-ups operate in a highly uncertain environment, many companies are not always able to perform as per their financial projection. Equally, some companies exceed the projection by a long mile if they are doing well.

♦ Illustrative Calculation of Angel Tax.

♦ Exemption/Relief To Some Start-ups.

Major Relief has been granted to Start-ups by The Department for Promotion of Industry and Internal Trade in super session of all earlier notification by means of issuing New Notification dated 19 Feb 2019

• Start-up Meeans:-The entity shall be considered as Startup for a period of 10 years (earlier 7 years) subject to turnover not exceeding 100 crores (earlier 25 crores) and the entity should work towards innovation, development or improvement of products or services.
• Exemption from Section 56(2)(viib):-
  • Aggregate amount of paid up share capital and share premium of the startup after the proposed issue of shares does not exceed Rs. 25 crores (Earlier 10 Crore).
  • In calculating the above limit of 25 crores non-residents, venture capital funds (‘VCFs’) and venture capital company, registered with SEBI are not to be included. Accordingly shares can be issued to such excluded investors without any limit and still the Startup will be eligible to claim exemption u/s 56(2)(viib) of the Act provided the shares beyond the threshold limit are issued to the excluded investors.
  • Startup has obtained a report from a merchant banker specifying the fair market value of shares in accordance with Rule 11UA of the Income-tax Rules, 1962.

Further, to be eligible for the exemption, there are restrictions on investments made by the start-ups which are as below-

• Capital contribution made into any other entity;
• Investments in shares and securities;
• Investment in land and building (whether a residential house or not), other than that used by the Start-up for its ordinary course of business
• Loans and advances, other than those extended by the Start-up in its ordinary course of business
• Jewellery other than that held as stock in trade.
• Motor car, yacht, air craft or any other mode of transport whose actual cost exceeds Rs 10 Lakhs.
• any other asset, whether in the nature of capital asset or otherwise, of the nature specified in sub-clauses (iv) to (ix) of clause (d) of Explanation to clause (vii) of sub-section (2) of section 56 of the Act.

As a part of compliance, the start-up is also required to file a declaration in the prescribed form stating that above conditions are fulfilled. The notification also provides that, in case the start-up which has claimed an exemption under section 56(2)(viib) of the Act, makes an investment in any of the above specified investments before the end of seven years (from the end of the latest financial year in which the shares are issued at premium), the exemption availed under the said section shall be revoked retrospectively.

As the investment in securities is prohibited, the start-up will not be eligible to invest in mutual funds as well and investments would be restricted to other modes like fixed deposits, government bonds etc. Further, it is pertinent to note that the criteria of an investor having a specified return on income and net worth is done away with as provided in the earlier notifications.

Overall, the notification provides some relief (which was overdue from a long time) in terms of enhancing the limits to qualify as a start-up, and provides an additional incentive in the form of increase in aggregate amount of share capital and share premium post issue of shares (INR 25 crores for residents and no limit for non-residents), the restrictions on investments to be made by start-ups are quite stringent and impose challenges on the start-ups and their operations.

♦ Pain Point of Start-ups.

The tax authorities have started issuing demand notices to startups to pay the angel tax by end-March. The latest notices specify the exact amount startups are required to pay along with the calculation of the taxes.The Central Board of Direct Taxes (CBDT) had issued a notice asking tax officers not to use “coercive measures” to recover the outstanding amount from the startups. The Department of Industrial Policy and Promotion (DIPP) is also looking into the angel tax issue and assured that the government would not harass the angel investors and start-ups (News).

I hope that the government may seek to resolve the issue in the months to come, but that too may not have a retrospective effect on the angel tax controversy.