Removal of Angel Tax: A New Era of Investment or Litigation?

Summary: Angel tax, introduced in 2012 under Section 56(2)(viib) of the Income Tax Act, aimed to curb money laundering by taxing equity investments that exceeded the fair market value (FMV). While its intention was to regulate unlisted companies receiving inflated capital, it created confusion due to valuation discrepancies, lack of clarity, and complex compliance. Many startups faced harassment as their cases were reopened under Section 148, placing them at a disadvantage. The tax also deterred investors, restricting capital flow to startups. With the Indian government’s initiative to foster innovation, the Department for Promotion of Industry and Internal Trade (DPIIT) pushed for the removal of this tax. The Finance Act 2024 abolished the angel tax from April 2025 onwards, a move hailed as beneficial for startups and investors alike. The removal is expected to boost both domestic and foreign investments, create jobs, and ease regulatory burdens. However, concerns remain regarding the absence of retroactive relief for ongoing litigations, potential misuse of tax exemptions, and lingering challenges around share valuations. Tax authorities may face difficulties in balancing genuine investments with preventing fraudulent activities.

What is angel tax

In the early stages of any businesses, it often requires external funding. Businesses procure these funds either by borrowings or by issue of equity. Startups, as lacking substantial assets for collateral security, typically prefer the route of offering equity.

However this funding came under the lenses of taxman, when Section 56(2)(viib) was inserted through the Finance Act of 2012. Provisions of this section were aimed to tax the amount when the equity was offered for more than Fair Market Value (FMV) of the shares. The amount in excess of FMV was proposed to be tax under the head of “income from other sources.

The primary purpose of this tax was for the purpose of keeping check over unlisted companies receiving funding from investors and to curb money laundering.

This tax so levied is commonly referred as “angel tax”.

Who are the angel investors

Angel investors are individuals or institutions that provide capital to early-stage businesses with high growth potential. Unlike venture capitalists, they typically invest smaller amounts and focus on industries where they have expertise. Beyond funding, angel investors offer startups valuable industry knowledge, strategic guidance, and access to their network, including potential customers, business partners, and other investors.

Introduction of Angel Tax – 2012 Budget Memorandum

The Finance Bill 2012, seeks to tax share premium in excess of the fair market value. The excess amount is to be treated as income from other sources.

As per the memorandum to Finance Bill 2012-

Section 56(2) provides for the specific category of incomes that shall be chargeable to income-tax under the head “Income from other sources”.

It is proposed to insert a new clause in section 56(2). The new clause will apply where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares. In such a case if the consideration received for issue of shares exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares shall be chargeable to incometax under the head “Income from other sources. However, this provision shall not apply where the consideration for issue of shares is received by a venture capital undertaking from a venture capital company or a venture capital fund.

Further, it is also proposed to provide the company an opportunity to substantiate its claim regarding the fair market value. Accordingly, it is proposed that the fair market value of the shares shall be the higher of the value—

(i) as may be determined in accordance with the method as may be prescribed; or

(ii) as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value of its assets, including intangible assets, being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature.

This amendment will take effect from 1st April, 2013 and will, accordingly, apply in relation to the assessment year 2013-14 and subsequent assessment years

Issues in Taxation after introduction of S. 56(2)(viib)

The purpose and intention of introducing angel tax was noble and it was introduced for a good cause to check the inflow of black money, still in reality, it brought more confusion, both amongst taxman and tax professionals due to uncertainty due to following reasons –

a. Disparity with valuations methods prescribed under Foreign Direct Investment Regulations and Income Tax.

b. Lack of clarity in the valuation methodology and undertaking fresh evaluation.

c. Valuation issues when there is an issuance of right shares, bonus shares, amalgamation/demerger etc.

d. Valuation issues at the time of conversion of convertible instruments into equity, etc.

e. Difficulty for taxman in identifying the difference between legitimate investments and money laundering.

f. Lot of cases were reopened u/s 148, thereby increasing the workload of taxman and it also sent a wrong signal among taxpayers as they are being harassed.

All these issues placed Indian startups at a disadvantageous stage.

Industry Scenario:

With an intent to build a strong ecosystem for nurturing innovation, startups and encouraging investments in startup ecosystem of the country, the Government of India, launched the ‘Startup India’ initiative on 16th January 2016.

(i) For attaining specific objectives, various programs are implemented by the Government under the said initiative.

(ii) Sustained efforts by the Government have led to an increase in the number of Department for Promotion of Industry and Internal Trade (DPIIT) recognised startups to 1,17,254 as on 31st December 2023.

(iii) These recognised startups are reported to have created over 12.42 lakh direct jobs creating significant economic impact.

(iv) 55,816 startups have at least one-woman director as on 31st December 2023.

(v) The statistics of start-up is as under:

(Source: https://pib.gov.in/PressRelease)

Industry Concerns about Angel Tax – Startups and Capital Flow: A Strained Relationship

The Angel Tax has been a thorn in the side of the Indian startup community. Industry claimed that Angel tax, is severely restricting the flow of capital. Many experts were of the opinion that the Angel Tax significantly impacting access to generate funds for start-ups and creating a barrier to innovation and ease of doing business.

Department for Promotion of Industry and Internal Trade (DPIIT), after extensive consultations with industry associations and the startup ecosystem, was vociferous to dismantle the Angel Tax. DPIIT Secretary Rajesh Kumar Singh emphasized the significance of for removal of this tax highlighting that its removal going to significantly boost capital formation within the country.

The Confederation of Indian Industry (CII) also echoed this sentiment in its budget recommendations, stating that the tax’s removal “will greatly aid capital formation.” This call for repeal has intensified amidst the ongoing funding slump, with investments into startups plummeting to a five-year low in 2023. Sanjiv Puri, CII President, in the Budget Recommendation, had said, “Taxing early-stage investments stifles innovation and entrepreneurial spirit. Removing this shackle would unleash a wave of capital, propelling the startup ecosystem to new heights.”

(Source: https://www.businesstoday.in/)

Abolishing the Angel Tax in Budget 2024

Amendment of Section 56 of the Act

Section 56 of the Act is related to Income from other sources.

2. Vide Finance Act, 2012, a new clause (viib) was inserted in sub-section (2) of section 56 to provide that where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares, if the consideration received for issue of shares exceeds the face value of such shares, the aggregate consideration received for such shares exceeding such fair market value shall be chargeable to income tax under the head “Income from other sources”.

3. It has been decided by the Government to sun-set the provisions of clause (viib) of sub-section (2) of section 56 of the Act. Consequent to said decision, amendment to clause (viib) of sub-section (2) of section 56 of the Act is being carried out to provide that the provisions of this clause shall not apply from the assessment year 2025-26.

4. This amendment is proposed to be made effective from the 1st day of April, 2025, and shall accordingly apply from assessment year 2025-26.

Implications of removal of Angel Tax

This abolishing of angel tax is a positive development for the startup community as a whole. The government has come forward to create a more favourable atmosphere for Investment in India. This step has created favourable atmosphere in India’s startup ecosystem, which is the third largest in the world, and aiming to become a $ 10 trillion economy by 2030.

The positive impact as expected by abolishing the angel tax provisions are summarised below:

1. For Start-ups:

a. The Indian startup ecosystem likely to be more appealing to both foreign and domestic investors, as complex tax regulations are no longer a barrier.

b. With more investment flow, startups can look forward to expand its operations, hire talent, and develop innovative products. This, in turn, will help a job creation.

2. For Investors:

The removal of the angel tax will help to reduce the risk associated with the valuation exceeding the fair market value. This will help to increase investors’ confidence, thereby providing startups with easier access to much-needed funds.

3. Foreign Direct Investment:

a. It will make India a more attractive destination for foreign capital, signalling a more business-friendly and open regulatory environment.

b. Foreign investors can perceive India as a stable and favourable market.

c. By eliminating the complexities and potential tax liabilities associated with the angel tax, it will reduce uncertainties on the taxation issues.

4. Reduction in compliance:

a. The tax payers can get relieved from the requirement of complex tax filings, justifications, and audits.

b. Lowering of compliance costs, will reduce administrative overhead, frees up resources, and creates a more efficient and streamlined environment for startups to secure investments and drive growth.

c. This will help to result in lesser enquiries and burden of paper work with the tax authorities leading thereby reduction in valuation disputes with tax authorities.

5. Alignment with the Govt Policy

a. Removal of the angel tax is a significant step in supporting the Startup India initiative, encouraging innovation and job creation, and boosting the ease of doing business in India.

b. By eliminating this tax, the government reinforces its commitment to fostering and nurturing ecosystem for startups, free from unnecessary financial barriers and regulatory hurdles.

c. This move aligns with international best practices, enhancing India’s global competitiveness and supporting the vision of making India a global innovation hub.

d. It demonstrates the government’s dedication to fulfilling its policy commitments, building trust with the startup community, and promoting a business-friendly climate.

e. Overall, the removal of the angel tax is a key milestone in India’s efforts to become a startup-friendly nation, driving growth, innovation, and employment through a supportive and inclusive ecosystem.

Issues still needs considerations:

Removal of Angel Tax would certainly raise issues both for taxpayers as well as tax authorities.

Some of the key concerns include:

From Taxpayer’s point of view:

a. Thers is no clarification as to why the Govt has withdrawn the provisions.

b. There is no corresponding amendment in the provisions of Section 2(24)(xvi).

c. The ambiguity still prevails as to how the taxpayers expected to justify valuation of shares in case the query from the tax authorities.

d. Abolishing of provisions have prospective applicability, the taxpayers have no relief with regard to existing litigations.

e. The excess payment over FMV may still come under the provisions of other sections such as Section 68 (unexplained cash credits).

From Tax authorities’ point of view:

a. The primary concern would remain regarding potential misuse of the exemptions provided.

b. The tax authorities concern would be regarding non-genuine entities taking advantage of the exemptions and introducing unaccounted money into the system through inflated valuations.

c. The issue valuation Challenges remains as like in the case of taxpayers.

d. Tax authorities need to wait for CBDT Guidelines and also need to explore the adequate tools to detect the fraudulent transactions disguised as startup investments.

e. They need to maintain the perfect balance to avoid the hardship to genuine investors.

f. Foreign investments, especially from tax havens, remain a concern. This includes concerns over round-tripping, where Indian funds are sent abroad and then re-invested into the country as foreign investments.