Introduction: India’s entrepreneurial landscape has flourished in recent years, marked by the emergence of numerous startups across various sectors. Amidst this growth, the concept of Angel Tax has sparked debate and attention. It is imperative for stakeholders to grasp the nuances of Angel Tax, including its impact on startups, investors, and regulatory frameworks.
In recent years, India has witnessed a strong and sudden growth in entrepreneurial activities, with a significant number of startups emerging across various sectors. While the government has been supportive of this thriving ecosystem, one aspect that has garnered attention and sometimes controversy is the concept of “Angel Tax.” Angel Taxation in India has been a subject of debate, and it is crucial for entrepreneurs, investors, and policymakers to understand its implications.
Who are Angel Investors?
Angel investors are high-net-worth individuals who invest their personal income in business start-ups or small and medium-scale companies. They are like an angels for startups.
What is Angel Tax?
Angel tax is levied solely on investments from resident investors. Notably, it does not apply to investments from non-residents or venture capital funds.
Angel Tax, formally known as the ‘Section 56(2)(viib)’ of the Income Tax Act, was introduced to restrain money laundering and tax evasion by taxing funds received by a closely-held company from an unrelated investor. The term “angel” in Angel Tax refers to angel investors, who are individuals investing in startups in exchange for ownership equity.
The Controversy: While the intention behind Angel Tax was to prevent the misuse of funds and maintain transparency, it became a cause for concern, particularly for startups. The tax was applicable to the excess amount paid by investors over the fair market value of the shares issued by the startup, leading to situations where startups were taxed on the perceived premium of their valuation, even if they were not making profits.
Startups argued that the valuation of their early-stage ventures, which often lack tangible assets and revenue streams, is subjective and may not reflect the true value of the business. The imposition of Angel Tax resulted in a cash crunch for many startups, hindering their growth and innovation.
Government Reforms: Recognizing the challenges faced by startups, the Indian government has taken steps to address the issues related to Angel Tax. In 2019, the Department for Promotion of Industry and Internal Trade (DPIIT) introduced significant changes to the Angel Tax framework. The key amendments include:
1. Exemption for Recognized Startups: Startups that are officially recognized by the DPIIT are now exempt from Angel Tax. To be eligible for this exemption, startups must meet certain criteria, including innovation, scalability, and a focus on job creation.
Criteria for the startups to meet the angel tax exemption:
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- Startup’s paid-up capital and share premium must not exceed Rs. 25 crore post share issuance.
- Fair market value certification by a merchant banker is mandatory.
- Angel investors can avail 100% tax exemption if investing in startups with higher fair market value, subject to conditions: average income not exceeding Rs 25 lakh and net worth of Rs 2 crore in the previous 3 fiscal years.
- Tax holiday for three consecutive years from business incorporation, exempting startups from paying taxes.
- Approval from an 8-member interministerial board is required for angel tax exemption.
2. Valuation Guidelines: The government issued guidelines to standardize the valuation process, providing more clarity on how startups’ valuations are determined. This aimed to reduce disputes between startups and tax authorities.
3. Increased Thresholds: The threshold for defining a startup was increased to include entities with a turnover of up to Rs 100 crores, providing relief to a broader range of startups. The amount raised from venture capital firms, NRIs and other specific companies is not to be included in calculation.
4. Share Premium Justification: Startups are now required to justify the share premium by submitting a report from a merchant banker or a registered valuer to establish the fair market value of shares.
What is Angel Tax Rate?
Angel Tax is levied at a hefty rate of 30.9% on net investments in excess of the fair market value. The excessive amount over and above fair market value is taxable as “income from other sources” and tax imposed on it is called as angel tax.
For example, if your startup secures a Rs 50 crore investment by issuing 1 lakh shares to an Indian investor at Rs 5000 each, with a fair market value of Rs 2000 per share, the fair market valuation totals Rs 20 crore. Consequently, angel tax is applicable on the excess amount above the fair market value, which amounts to Rs 30 crore (Rs 50 crore – Rs 20 crore). Therefore, the tax due on this transaction would be Rs 9.27 crore, calculated at 30.9% on the excess Rs 30 crore.
Conclusion: Angel Taxation in India has undergone significant changes in response to the evolving startup landscape. The government’s efforts to ease the burden on startups and promote innovation are commendable. However, ongoing dialogue between stakeholders, continuous refinement of regulations, and proactive support for the startup ecosystem are essential for fostering a thriving entrepreneurial environment in India. As the landscape continues to evolve, staying informed about these developments is crucial for entrepreneurs, investors, and policymakers alike.
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The above article is written by Ms. Shruthi Nyavanandi (Shruthi.Nyavanandi@abacussolutions.co.in) and reviewed by Mr. Suyash Tripathi (suyash.tripathi@abacussolutions.co.in).
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