Summary: Angel Tax, introduced in 2012, was aimed at curbing money laundering through startup investments but became a financial strain on Indian startups. It taxed investments exceeding a company’s fair market value at 30.9%, discouraging early-stage funding. The Finance Act, 2023, extended this tax to non-resident investors, raising concerns about reduced foreign capital flow and conflicts with FDI regulations. Valuation inconsistencies and arbitrary assessments further burdened startups. Recognizing these challenges, the Indian government abolished Angel Tax for all investor categories in the 2024-25 Union Budget, effective from FY 2025-26. This move eliminates a significant barrier to funding, improves startup valuations, and aligns India with global investment standards, fostering a more investor-friendly ecosystem. However, ongoing Angel Tax cases before April 1, 2024, will continue, indicating the need for clarity on retrospective implementation.
According to the Indian Tech Startup Funding Report 2023 by Inc42, start-up funding fell by 60% in 2023 to USD 10 billion.[1]
INTODUCTION
Securing funding is often a make-or-break moment for start-ups. It is a lifeline that helps them grow and innovate. Investors, especially in the early stages, bet on the company’s potential rather than its current financials. However, when a start-up raises funds at a higher valuation, it can sometimes attract scrutiny from tax authorities.
For instance, there is a founder of a tech start-up. He obtained a ₹1 core investment from an investor who agreed to pay ₹100 per share and recognized the potential of his business. Upon reviewing the transaction, tax authorities determined that the shares’ fair market value was ₹80. The ₹20 discrepancy per share was viewed as taxable income rather than merely an investment, which put a strain on the start-up’s finances and discouraged both the investment culture and the start-up.
BACKGROUND
Then-finance minister Pranab Mukherjee first proposed the idea of an angel tax in the 2012 Union Budget The chief objective was to avert money laundering by investing in new businesses and to identify fraudulent companies if such cases were discovered.
Although introduced in 2012 but the ‘angel tax’ was expanded through the Finance Act of 2023, to discourage the generation and utilisation of unaccounted money through investments in closely held companies.
WHAT IS ANGEL TAX?
A system of taxes imposed on investments made by angel investors in start-up companies is called the Angel Tax, or Angel Investment Tax. These investments typically take place in the early stages of a startup’s development when it needs seed money to grow and expand.
OBJECTIVE:
Angel tax goals fall into three primary categories:
1. Economic growth,
2. Revenue-generating,
- Regulatory.
Ensuring compliance with tax laws and preventing dishonest practices in the start-up funding sector are the goals from a regulatory perspective. The goal of taxing angel investments is to raise money for governments to spend for public services and infrastructure projects like schools and roads.
Additionally, angel tax is viewed as a tool to boost economic development by encouraging innovation, entrepreneurship, and the creation of jobs through the development and growth of businesses.
ANGEL TAX IN INDIA
In India, contributions made to a business that exceed its market value are subject to a hefty 30.9% angel tax. Angel taxes from new businesses seeking investment must be sent to the Income Tax Department.
Assume your firm has raised Rs 40 crore by selling an Indian investor 80,000 shares at Rs 5,000 each. The fair market value of a stake in the start-up is Rs 2,200 per share. As a result, the shares are currently valued at Rs 17.6 crore at fair market price. The excess amount over the fair market value, which is Rs 22.4 crore(Rs 40 crore – Rs 17.6 crore), is subject to angel tax. The tax due on this transaction would be Rs 6.92 crore (30.9% on Rs 22.4 crore).
LEGAL PROVSIONS:
A s per section 56(2)(viib)[2] of the Income Tax Act, 1961, any extra or excess premium received by a companies which are unlisted i.e. other than a public listed company by the resident of India exceeding the Fair Market Value (FMV) of the share issued is liable to tax in the hands of such company.
KEY PARTIES
I. START-UP
Angel investors are essential to start-ups because they offer the early-stage capital needed to transform creative concepts into successful ventures. Additionally, the support of angel investors enhances a start-up’s reputation, drawing in more capital and raising the likelihood of obtaining additional investment rounds.
II. ANGEL INVESTOR
Angel investors provide start-up firms with their first cash and advice. Business angels are another name for these. Individuals who have a great amount of personal capital themselves usually take part in ventures which involve an element of risk, although a large potential for returns.
Angel investors provide not only capital, but guidance on best ways of transforming business idea into a thriving business based on experience as experts in a niche market or as business operators. In addition to financing, these angel investors usually provide strategic guidance and contacts in given industries, which act as a critical support for businesses in an attempt to make a name for them.
III. GOVERNMENT
Enforcing and monitoring Angel Tax legislation is the responsibility of the government and tax officials. The Department of Direct Taxes and the Income Tax Department supervise the tax determination, making sure startups adhere to value standards. Startups that qualify for Angel Tax reduction receive government approval from the Department of Promotion of Industry and Internal Trade. To solve tax issues in startup culture, the government implements reforms and computerized filing methods.
IV. EXCEPTIONS
- The Department of Promotion of Industry and Internal Trade (DPIIT) should recognize and certify the new or other start ups
- The start-up cannot make investments in jewelry, real estate, buildings, capital projects in other companies, vehicles that cost over Rs 10 lakh, or bank advances.
- The appraisal and fair market value must be ascertained by a certified merchant banker.
- The startup’s total paid-up capital must be less than or equal to ₹25 crore.
- The government and investors connected to the government, such as central banks, sovereign wealth funds, and international or multilateral organizations; when the government owns at least 75% of the company.
- Entities that is SEBI-registered as endowment funds, pension funds, and Category I Foreign Portfolio Investors (FPI).
- Funds that are not hedge funds and have more than fifty investors are also excluded, as are broad-based pooled investment vehicles.
FINANCE BILL, 2023
The Income-tax Act was altered under the Finance Act, 2023, to bring Non-resident investors under the angel tax provision.
Before the amendment, the law stated that the general rule for the start-up firm will be that they will be subjected to income tax under the category of “Income from other Sources” for that fiscal year if it acquires equity investment from a resident that surpasses the face value of the shares which earlier exempted the foreign investors
This new bill now is applicable to Non-resident investors as well, thanks to the recent change brought by the new 2023 bill This implied that startups who raised money from overseas investors would likewise have to pay taxes and will not be exempted
CHALLENGES
- Inclusion of Non-resident Investors
When Angel Tax started being imposed on contributions made by foreign venture capitalists, non-resident Indian investors, and non-resident investors, a big debate erupted in 2023. Angel Tax was leviable on domestic investors till now, but this made India unattractive for foreign investors. This action sparked concerns of foreign capital flows declining, since Indian businesses have a big dependency on foreign finance.
- Valuation Controversy and Subjective Estimates
One of the major battles of startups was a non-homogeneous process of valuation. The tax authorities systematically dismissed startups’ valuations, declaring the share prices excessive. In place of this, tax authorities re-calculated valuations on subjective or imprecise grounds, which imposed additional tax liabilities on startups.
- Conflict of FDI Regulations
Foreign investment startups have been in a predicament owing to inconsistencies between Foreign Direct Investment regulations and Angel Tax pricing regulations. While in FDI regulations, various pricing mechanisms such as discount cash flow pricing or international pricing systems can be followed, tax authorities in cases of Angel Tax have been asking for other, more conventional mechanisms.
- Angel Tax provisions were indiscriminate
Levied in different cases, such as in cases of:
1. Startups financed themselves in periods of financial distress in an attempt to survive, but investment nonetheless incurred taxation.
2. Bonus shares were issued to existing shareholders, inadvertently attracting Angel Tax liabilities.
3. Convertible securities (CCPS, CCDs) converted into equity, hence taxed in the absence of new investment. These stringent implementations deterred investors in critical moments of finance, making it tougher for startups to survive difficult moments.
PRESENT UNION BUDGET
With the presentation of the new union budget 2024-2025 the government of India recognized the angel tax as the block in the road of Indian investment, economy and start-up funding and it created and discouraged the start-up culture as this tax created a financial strain. Acknowledging this strain, the finance Minister through this budget abolished the Angel Tax for all investor categories effective immediately from the 2025-2026 Financial Year (FY)
LEGAL PROVISION: The proposed modification to the Income Tax Act, 1961, found in Clause 23 of the Finance Bill, 2024, will make the angel tax provision ineffectual as of April 1, 2025. Nevertheless, the bill also stipulates that on April 1, 2024, the aforementioned amendment shall be considered to have taken effect. It can be stated that ongoing cases and investigations pertaining to angel tax violations and evasions that were started prior to April 1, 2024, will stay unaffected and that proceedings will proceed against such tax evaders and violators in the absence of any specific guidance or circular regarding whether this change will be implemented retroactively.
IMPLICATIONS OF THESE NEW CHANGES
- Boosting Foreign Investment– Eliminates a major hurdle for foreign investors.
- Enhancing Startup Valuations-Enables startups to present market-driven valuations and removes the need to comply with arbitrary regulatory benchmarks.
- Aligning with Global Standards– Makes India more attractive to startups and investors globally and encourages cross-border collaborations and partnerships.
CONCLUSION
Despite the tax breaks given to businesses and investors, the angel tax has drawn a lot of criticism. The imposition of angel tax has hindered the growth of numerous Indian business owners. In this regard, some changes to the law are necessary to encourage young people to work in the startup sector.
An important turning point in India’s entrepreneurial history has been reached with the removal of the angel tax for all types of investors. The Indian government has shown its dedication to promoting innovation and drawing in foreign capital by eliminating a major financial and regulatory barrier.
REFERENCES
- Co-Leader|authorurl:https://www.ey.com/en_in/people/kt-chandy, authorsalutation:|authorfirstname:KT|authorlastname:Chandy|authorjobtitle:EY India Corporate Tax and Regulatory Services Partner and Private Tax, and authorsalutation:|authorfirstname:Surabhi|authorlastname:Marwah|authorjobtitle:EY India People Advisory Services Partner and Private Client Services Co-Leader|authorurl:https://www.ey.com/en_in/people/surabhi-marwah. How Amendments in Angel Tax Will Impact Companies. https://www.ey.com/en_in/insights/tax/how-amendments-in-angel-tax-will-impact-companies. Accessed 26 Feb. 2025.
- A Complete Guide on Angel Tax. https://www.adityabirlacapital.com/abc-of-money/what-is-angel-tax-guide-to-angel-tax. Accessed 26 Feb. 2025.
- Briefing, India. ‘Abolishing the Angel Tax in India: Applicable for FY 2025-26’. India Briefing News, 2 Dec. 2024, https://www.india-briefing.com/news/abolishing-the-angel-tax-in-india-applicable-for-fy-2025-26-35289.html/.
- Comprehending the Angel Tax Exemption. https://www.startupindia.gov.in/content/sih/en/bloglist/blogs/comprehending_the_angel_tax_Exemption.html. Accessed 26 Feb. 2025.
- ‘Angel Tax Abolished: A Relief for Indian Startups’. Singhania & Partners, https://singhania.in/blog/the-end-of-angel-tax-and-its-implications. Accessed 26 Feb. 2025.
- ‘Exemptions on Angel Tax’. Drishti IAS, https://www.drishtiias.com/daily-updates/daily-news-analysis/exemptions-on-angel-tax. Accessed 26 Feb. 2025.
- ‘Angel Tax and Capital Gain Tax’. Drishti IAS, https://www.drishtiias.com/daily-updates/daily-news-analysis/angel-tax-and-capital-gain-tax. Accessed 26 Feb. 2025.
[1] ‘REPORT: Indian Startup Funding Lowest In 7 Years In 2023’. Datalabs, https://inc42.com/reports/indian-tech-startup-funding-report-2023/. Accessed 26 Feb. 2025.
[2] THE INCOME TAX ACT, 1961(ACT NO. 43 OF 1961) s. 56.
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