Amrutha Raman Kartha
Rapid changes have been occurring in India’s economy, especially with the emergence of start-ups as a major engine for innovation and job creation. India now has one of the fastest-growing start-up ecosystems in the world thanks to the Government of India’s Digital India plan, the growth of e-commerce platforms, and the proliferation of app-based services. Although there are many prospects, taxes have frequently presented a major obstacle for startups in their early phases of development.
The “Angel Tax,” which had a direct effect on funding for early-stage start-ups, has been one of the most contentious issues in this context.
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Understanding Angel Investment and Its Taxation
When a start-up is just getting off the ground, it usually can’t rely on traditional bank loans. Instead, it turns to alternative sources like crowdfunding, micro-finance, or angel investors. Out of these, angel investment is especially helpful—not only does it give much-needed funding, but it also comes with guidance and support from experienced investors who take an equity stake in the company.
The problem, however, is that the Indian tax system initially made this kind of investment tricky. Back in 2012, the government added Section 56(2)(viib) to the Income Tax Act, 1961, which said that if a start-up raised money from an Indian investor at a value higher than its Fair Market Value (FMV), that extra amount would be treated as “income from other sources” and taxed [1].
In simple terms, if a start-up sold shares at a premium above what officials considered the “fair value,” the difference was taxed at the standard corporate rate—sometimes over 30%. For young companies struggling for funds, this was a huge burden.
The Criticism Against Angel Tax
The introduction of angel tax received widespread criticism, especially from the start-up community. For young companies that are usually still in their product development or market-testing phase, imposing such a tax appeared unfair and impractical. Start-ups often do not have steady revenues or profits, and their valuation is usually based on future potential rather than current financials. This made it extremely difficult to justify their Fair Market Value (FMV) to tax authorities, who relied on rigid formulas rather than the dynamic, speculative nature of start-up investments.
As a result, several start-ups had to pay significant amounts in taxes, even though the funds they received were meant for growth and expansion. This discouraged many Indian investors from backing new ventures, creating a chilling effect on entrepreneurship in the country.
What made the situation worse was the international comparison. Countries like Singapore, the USA, and the UK actively support angel investors by providing tax credits, exemptions, and research grants to encourage innovation. India, however, took the opposite route by burdening domestic investors with taxation, while ironically keeping foreign investors outside the purview of Section 56(2)(viib). This created a system where local investors were penalized while overseas investors faced no such restrictions.
Policy Reforms and Relief for Start-Ups
Acknowledging the negative impact, the government introduced reforms to reduce the burden on entrepreneurs. On June 14, 2016, the Central Board of Direct Taxes (CBDT) issued a notification amending Section 56(2)(viib), exempting eligible start-ups from the angel tax requirement [2].
This was further supplemented by a notification from the Department of Industrial Policy and Promotion (DIPP) on February 17, 2016, which laid down a clear definition of what constitutes a start-up. According to this notification, an entity could be recognized as a start-up if:
- It was incorporated in India within the last five years.
- Its annual turnover did not exceed INR 25 crore in any financial year.
- It obtained recognition from the Inter-Ministerial Board of Certification.
Once certified, start-ups fulfilling these criteria were exempted from paying angel tax, which gave them much-needed relief and allowed them to channel their resources towards growth and innovation.
A Step Towards Digital India
The exemption from angel tax has been regarded as a progressive and much-needed policy shift. It not only restored the confidence of local investors but also brought India closer to international standards of start-up promotion. By reducing the fear of heavy taxation, more investors were encouraged to support young ventures, which in turn helped strengthen India’s start-up ecosystem.
Although procedural requirements such as certification still remain, these reforms are a significant step towards realizing the goals of the Digital India initiative, where taxation no longer acts as a barrier to innovation.
Conclusion
The debate around angel tax shows how important it is for taxation laws to strike a balance between revenue collection and economic growth. While taxes are necessary for the functioning of the state, excessive or arbitrary levies can discourage investment and hinder innovation. The government’s decision to amend the law and exempt eligible start-ups has therefore been a commendable move.
By aligning tax policy with the realities of the start-up ecosystem, India has created an environment where innovation is nurtured rather than restricted. This not only supports entrepreneurship but also strengthens the country’s position in the global economy.
References
[1] Income Tax Act, 1961, Section 56(2)(viib).
[2] Central Board of Direct Taxes (CBDT), Notification related to Tax Exemption on Investments above Fair Market Value (June 14, 2016). Available at: Startup India Notification (Last accessed: 12th January, 2019).
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Author: Amrutha R Kartha | Final year LLB student from Lovely Professional University
