What is Angel Tax in India?

So, precisely what is angel tax? ​Angel tax has been one of the most talked-about topics in the Indian startup ecosystem in recent years. But what exactly is angel tax, and why is it important to understand as an entrepreneur or angel investor in India? This comprehensive guide provides a deep dive into angel tax meaning, its implications, exemptions, and ways to avoid it.

Angel Tax Meaning

Angel tax refers to the income tax payable on capital raised by unlisted companies via the issue of shares where the share price exceeds the fair market value of the shares sold. This excess capital is treated as income and taxed accordingly.

In simpler terms, it is a 30% tax that startups must pay when they raise funding at a valuation higher than the ‘fair market value’. Tax professionals carefully decide this fair market value based on past financial performance and other factors.

Why is Angel Tax in India?

The Indian government introduced angel tax India provisions in Section 56(2)(viii) of the Income Tax Act in 2012 to detect money laundering in India. This was when black money hoarders increasingly used startup investments to legitimise their unaccounted cash.

The government introduced an angel tax India to curb the practice of money laundering in startups. However, it unnecessarily troubled the startups by forcing them to justify high market valuations against their revenues and assets.

Implications of Angel Tax

Since introducing the angel tax India provisions in 2012, startups in India have felt a significant impact. This section covers the most critical implications of angel tax on startups in India:

• Additional tax Burden: Startups must pay a 30% tax on the total funding amount they raise that is considered above the Fair Market Value (FMV). This high rate of taxation can drastically increase the cash burn for early-stage startups.
• Fundraising Difficulties: Investors are usually wary of funding startups that may attract angel tax, which can reduce their returns. Many funding deals have needed to be stalled due to the angel tax provision.
• Focus Shift From Business: Founders must spend time and resources handling angel tax provisions and the related legalities rather than focusing on growing their startups.
• Talent Drain: India has seen a rapid outward brain drain of talented startup founders who migrate to other countries over issues like angel tax.

Forms of Angel Funding

Angel funding refers to the capital raised by unlisted companies through share issues to angel investors. Typically, angel investors invest in startups for an equity stake in early funding rounds before venture capital investors invest.

The following sources of funding can be considered as angel funding and, hence, could attract angel tax in India:

• Funding from angel investing platforms and networks
• Capital raised from family members and friends
• Seed funding or pre-series rounds from angel investors
• Crowdfunding rounds involving the issue of shares

However, angel tax exemptions may apply under certain conditions.

Angel Tax Exemptions

The Department of Industrial Policy and Promotion (DIPP) is the government body overseeing the Startup India initiative. It aims to promote and enable startups through various measures.

As part of this, DIPP recently announced changes to angel tax norms applicable to startups and early-stage investments and introduced exemptions for startups recognised by the department. As per the revised notification issued by DIPP, startups will not have to pay any angel tax if the total capital raised via issuance of shares is within ₹ 10 crores. This includes past funding rounds as well as the existing round.

Additionally, the startup’s valuation after the latest funding round should not exceed ₹ 10 crores. These limits reduce the tax burden for early-stage startups within these thresholds. Further, the notification released by DIPP also lays down specific criteria that the investors must fulfill for the startup to claim tax exemption on angel investments.

Any resident investor who has invested or proposes to invest in a startup should either have the minimum average (as per the details in the Income Tax returns) income of twenty-five lakh rupees for the preceding three financial years or have a minimum net worth of two crore rupees as of the last date of the prior financial year.

While this aims to promote investments into startups, concerns have been raised that the income and net worth criteria set for angel investors must be lowered and might exclude many potential investors. Industry bodies have requested the government to relook at these thresholds to enable more angel funding in India and support entrepreneurship and startups.

How to Avail Income Tax Exemptions

The application process for angel tax exemptions is simple. This section covers the steps through which interested startups can avail themselves of income tax exemptions.

• A startup intending to apply for the exemption must fill out the application form ‘Exemption under Section 56’ along with certain documents.
• The application requires a report from any SEBI-registered Category-I merchant bankers specifying the fair market value of shares (as per rule 11UA of Income Tax Rules, 1962).
• An Inter-Ministerial Board constituted by DIPP then reviews the application. The eight-member board comprises members from various government departments and meets periodically to decide on the applications received.
• The exemption under Section 80 IAC of the Income Tax Act is granted for three consecutive years out of the first seven years from the date of incorporation of the Startup.

Any Private Limited company or a Limited Liability Partnership registered after 1 April 2016 can apply for this exemption. With a straightforward application and merchant banker’s report, startups can easily avail themselves of the tax exemption on angel funds. This simplifies the process and encourages more startups to apply.

Categories of Angel Tax Exemptions

Over the years, the Indian government has introduced several angel tax exemptions for DIPP-recognised startups and investors. Broadly, the following categories of funding received by startups are exempt from angel tax:

1. Funding Received from Registered Angel Investors

Angel tax is not applicable if a startup has raised funding from angel investors registered with SEBI or any recognised stock exchange. This allows genuine investors to fund startups while preventing money laundering by non-serious investors.

2. Investments up to ₹25 crore Valuation

As per the latest Section 56(2)(vii-b) amendment, DIPP-approved startups are exempt from angel tax on receiving angel funds if the total investment does not exceed ₹25 crores and the startup valuation is up to ₹ 10 crores.

3. Investments by Non-Residents

Investments made by non-resident Indians, foreign investors, VC funds, and AIFs (Category-I) are exempt from angel tax. This provision enables startups to raise growth capital from foreign sources without angel tax implications.

Important Details One Should Know

Investing in the services of a reputed merchant banker can help the concerned startup save a considerable amount of money that would otherwise be paid as angel tax. Interestingly, startups looking for a reputed merchant banker in their area can write directly to DIPP using their official email ID (dipp-startups@nic.in) to avail themselves of the services of a reliable merchant banker.

This Interministerial Board is critical in evaluating and approving startups for tax exemptions. With members from different government departments, it takes a holistic approach to reviewing applications under Section 56 and Section 80-IAC of the Income Tax Act. The periodic meetings ensure that applications are processed promptly.

Some startups have complained that finding an affordable merchant banker remains a challenge. To further ease the application process, experts suggest the government empanel some merchant bankers to provide these services to startups at fixed rates.

How to Avoid Angel Tax?

While exemptions have significantly reduced the applicability of angel tax, early-stage startups may still receive tax notices. Here are some tips to avoid getting an angel tax notice:

• Ensure the investor has SEBI registration to avoid any questions on the source of funds.
• Justify your startup valuation with relevant documentation on the business model and financial projections.
• Maintain meticulous records of investments received and filings like the issue of shares.
• Hire a good CA to review if the investment structure can attract angel tax.
• Respond to all tax notices diligently within the stipulated time

Conclusion

The Indian startup ecosystem has come a long way since the angel tax posed an existential threat to early-stage startups and investments. While some legacy issues remain, recent exemptions on angel funding have significantly boosted the startup funding ecosystem in India.

Understanding all the nuances of angel tax can help startups avoid getting tax notices that can hamper their growth journey. As the government aims to promote innovation and entrepreneurship in India, startups can expect more reforms in angel tax regulations in the future.

FAQs on Angel Tax in India

1. What is Angel Tax in India, and why was it introduced in India?

The Angel Tax taxes the capital raised by unlisted firms when the angel investors’ investments in these companies exceed fair market value. The government introduced the Angel tax to prevent money laundering and black money infusion into startups.

2. Which entities are subject to Angel Tax in India?

Angel Tax applies to Indian unlisted companies raising funds domestically or from foreign investors. DPIIT-recognized startups, however, can avail themselves of rule-based exemptions.

3. How is a startup’s fair market value (FMV) determined for Angel Tax purposes?

A certified valuer who qualifies to determine angel tax determines startups’ fair market value through approved methods like discounted cash flow or net asset value. A merchant banker can help startups prepare their fair market value report.

4. Are all startups in India exempt from Angel Tax?

Only the startups recognised by DPIIT that meet the required criteria on factors like turnover and incorporation qualify for Angel Tax exemptions.

5. What are the recent changes or reforms regarding Angel Tax in India?

Recent reforms on Angel Tax seek to reduce the tax burden on startups by providing exemptions to DPIIT-recognized startups and promoting advanced valuation methods for determining fair market value.

6. How does Angel Tax affect foreign investment in Indian startups?

Specific provisions in the Income Tax Act allow tax exemptions for genuine foreign investments in Indian startups under relevant sections. Adequate provisions exist to ensure that foreign funding in startups is not adversely impacted.

Author: All Content is verified by SMC Global Securities.