The Income Tax Act of 1961 introduced angel tax rules to monitor the funds that unlisted companies get from angel investors. The main goal was to prevent money laundering and the flow of illegal money into start-ups. According to Section 56(2)(viib) of the IT Act, if a resident invests in shares of an unlisted company at a price higher than their face value, the extra amount is taxed as ‘income from other sources.’ This rule, known as the ‘angel tax,’ was introduced in 2012 to stop the use of hidden funds as share premium. Non-resident investors were initially exempt because they already followed Indian exchange control laws. As more young professionals in India began starting their own businesses and raising funds, tax officers started paying closer attention to these companies’ valuations. To ease the burden, the Department for Promotion of Industry and Internal Trade (DPIIT) issued a notification in 2019 that allowed eligible start-ups to be exempt from angel tax. While this seemed like a positive step for businesses, the details revealed many complications.
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The Startup Exemption Challenge
Definition of a Start-up
A startup is a type of business entity that falls into the categories of a limited liability company, partnership, or limited liability company. It is characterized by being less than 10 years old and a turnover of less than Rs. 100 crores per financial year and focusing on activities related to the invention, development or improvement of products or services. However, companies created by splitting or reorganizing pre-existing companies are not classified as start-ups. Imagine a tech startup that has created a revolutionary app. If this start-up obtains intellectual property from another entity, there may be ambiguity regarding whether this constitutes the division of an existing business. The lack of clarity in this situation might cause significant difficulties for technology companies that depend on the transfer of intellectual property for their expansion.
Eligibility for Angel Tax Exemption
In order to be excluded from angel tax, a start-up’s total paid-up share capital and share premium after issuing shares must not exceed Rs. 25 crores. The start-up should refrain from investing in loans and advances, unless it is for routine business purposes. It should also avoid making capital contributions to other businesses, as well as investing in shares and securities. Start-ups are required to submit Form 2 to DPIIT, indicating their adherence to these regulations. If a start-up violates these restrictions within a period of seven years, the exemption will be retrospectively cancelled. For example, let’s take a modest start-up that obtains angel funding at an early stage. If this start-up chooses to allocate capital to mutual funds in order to maintain liquidity, it runs the risk of forfeiting its exemption. Likewise, if the company provides its employees with small loans as a regular element of its commercial activities, it may not qualify for the exemption.
Although early-stage companies may typically meet these standards, companies that have received funding beyond Series A or those in areas that require strategic partnerships sometimes find it difficult to comply, resulting in their adherence to angel tax regulations and fair market value (FMV) requirements.
The No-Startup Exemption Challenge
Extension to Non-Resident Investors
The Finance Bill, 2023 extended angel tax to non-resident investments in unlisted Indian companies starting April 1, 2024. The Finance Ministry later exempted investments from 21 countries, including the USA, UK, and France, but excluded major FDI sources like Singapore and Mauritius. This exemption applies to SEBI-registered entities, endowment funds, pension funds, and broad-based pooled investment vehicles, creating confusion and limiting applicability to mutual funds over venture capital or private equity funds. For example, an Indian start-up might receive significant investment from a venture capital firm based in Singapore. Despite being a major source of FDI, this investment would still be subject to angel tax, complicating the funding process.
Valuation Challenges under FEMA and IT Act
India uniquely requires separate valuation reports for funding compliance with three regulators: MCA, IT Act, and RBI under FEMA. FMV under FEMA acts as a pricing floor, while the IT Act treats it as a ceiling, complicating compliance. Non-resident investors prefer higher FMV premiums for convertible instruments to protect economic rights, but exceeding FMV attracts about 30% tax under the IT Act.
Recent Amendments and Possible Solutions
New Valuation Methods
In September 2023, the Central Board for Direct Taxes (CBDT) introduced new valuation methods, increasing options from two to seven, including methods like comparable company multiple and option pricing. This provides more flexibility but requires valuations within 90 days of share issuance. For example, a start-up might use the option pricing method to better reflect the potential future value of its innovative technology. This flexibility helps align the company’s valuation more closely with market realities.
VC Funds/AIFs
The amended rules allow price matching for resident and non-resident investors with VC funds or specified SEBI-registered Category I and II AIFs. This could encourage non-resident investors to set up fund structures in India but requires strong bargaining power from investee entities. Consider a start-up in the clean energy sector. By matching prices with a VC fund, it might secure better investment terms from non-resident investors, who are now more willing to invest in promising Indian start-ups.
Safe Harbor Variation
A “safe harbor” clause allows a 10% variation between valuation price and issue price, accounting for forex fluctuations and other economic indicators. This benefits start-ups and investors by acknowledging fundraising volatility. For instance, a start-up raising funds during a period of significant economic fluctuation can benefit from this safe harbor clause, providing a buffer against unexpected valuation swings.
Impact on Ease of Doing Business
Angel tax provisions and their extension complicate fundraising transactions, especially those involving primary subscriptions and secondary acquisitions. Structuring these transactions within regulatory confines is challenging. Solutions include issuing convertible equity instruments at high face value, investing through compulsorily convertible debentures (CCDs), and adopting innovative valuation approaches. However, these measures increase compliance costs and risks.
Conclusion
Despite efforts to make things easier, angel tax rules still make doing business in India challenging, especially for cautious foreign investors who prefer simpler setups. The complicated regulations mean that lawyers and tax experts need to come up with clever strategies, which takes away from the main goal of keeping unaccounted money out and makes things harder for start-ups.
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