The Controversy of Angel Tax in India: Understanding the Implications for Startups
In this blog post, we will explore the issue of angel tax in India and its impact on startups in the country.
Table of Contents
In this blog post, we will explore the issue of angel tax in India and its impact on startups in the country. We will discuss what angel tax is, how it is implemented, and the controversy surrounding its application to startups. We will also provide an overview of the recent developments and changes related to angel tax in India, and discuss the implications for startups looking to raise funding from angel investors. By the end of this post, you should have a better understanding of the issues surrounding angel tax in India, and how it may impact your startup.
What Is Angel Tax?
By selling their closed shares, unlisted start-ups can raise funds from resident investors. When start-ups receive investments in excess of their "fair market value," they are subject to an angel tax. The perceived profit is treated as income from other sources, and it is taxed at 30%, known as angel tax. It should be noted that the angel tax does not apply to investments made by venture capital firms or foreign investors. It is restricted to investments made solely by Indians.
The Definition Of Fair Market Value
A startup's fair market value is difficult to ascertain. The Income Tax Act of 1961, Section 56, explains how to compute this value. It can be calculated by taking into account intangible assets such as goodwill, know-how, patents, licenses, copyrights, and movable assets.
However, this definition is causing consternation among entrepreneurs and the income tax department. In India, income tax is strictly enforced by the rule book. As a result, while calculating the fair value, it is impossible to accurately estimate the projected growth of start-ups.
Who Are Angel Investors?
Angel investors are wealthy individuals who can contribute their own capital to a start-up in exchange for ownership equity. Angel investors, as opposed to investment firms, use their own money to invest in start-ups. These investors are frequently impressed by start-up offerings and do not seek a profit margin. They might also invest out of goodwill.
Informal investors, angel funders, private investors, seed investors, and business angels are other terms for angel investors. Due to complex taxation policies, very few wealthy Indians actually take on this role. With a more open system, more Indians will invest in start-up ventures in India.
Why Is Angel Tax Important?
Unlike in the United States, angel investors in India do not receive a tax break for their investments in small businesses. As a result, people can invest their illegal funds in start-ups and make it legal. The angel tax was enacted to prevent money laundering in the name of investment.
However, determining the fair market value of a startup has remained a source of contention. Because measuring intangible assets is difficult, only a subjective rating can be provided. However, different people may view this rating differently. If the value is set high, start-ups will benefit because they will have to give up less equity.
Angel Tax Legal Status in India
Assume a closely held company issues equity shares, and an investor purchases them at a price higher than their fair value. The excess amount will be treated as income from other sources by the company. As tax, the company must pay 30% of the excess amount plus the applicable cess value.
If the closely held company is a new venture, the tax paid on such excess earnings is known as angel tax. The person who buys its stock is known as an angel investor.
This rule, however, will not apply in the following circumstances:
- Any venture capital undertaking (certified by SEBI) purchases shares from a venture capital company or a venture capital fund.
- A company purchases shares from a class or classes of people as determined by the central government.
Angel Tax Exemptions
The government recently relaxed the procedure for applying for angel tax exemption. Any eligible start-up can apply for angel tax exemption by contacting the Department of Industrial Policy and Promotion (DIPP) with supporting documentation. Along with these documents, applications for DIPP-recognized start-ups will be forwarded to the Central Board of Direct Taxes (CBDT).
The CBDT will accept or deny the request within 45 days of receiving the application.
Should Startup be concerned about Angel Tax?
Start-ups in India are primarily funded by venture capital firms or foreign investors. Angel investors are few and far between. Only accredited start-ups are exempt from the angel tax. Only a few start-ups are currently certified. More investors would be interested in investing in start-ups if the angel tax rules were relaxed.
Reason for Introducing Angel Tax
The entire thrust of such taxation is to bring measures to tax the excess share premium received by private companies over and above the FMV, which was widely used as a mechanism for accounting for previously unaccounted money and receiving corporate kickbacks. This is essentially one of the anti-abuse provisions put in place to prevent money laundering.
Angel Tax and Start-ups
According to a survey conducted jointly by LocalCircles and the Indian Venture Capital Association, nearly 73% of start-ups received one or more Angel Tax notices. Later, based on representations and because shares are issued at a premium in the startup ecosystem and value the company's long-term potential, which may not be captured under the valuation methodology specified (Net Asset Value - NAV) under this section, an exemption was granted to start-ups recognized by the Department for Promotion of Industry and Internal Trade. The exemption, however, was granted subject to the following conditions: - Within 7 years of the end of the most recent fiscal year in which the shares are issued at a premium, start-ups should not invest in
- Land or buildings (except for own use),
- Shares and securities,
- Capital of other entities,
- Jewellery and artifacts.
- Any mode of transport where the actual cost exceeds Rs 10 lakh, other than in a normal, ordinary course of business.
Furthermore, the aggregate amount of paid-up share capital and share premium of the start-up post-issue of shares raised from non-residents, Venture Capital Company ("VCC") or Venture Capital Fund ("VCF"), or a specified listed company with a net worth of at least Rs 100 crore as on the last day of the preceding financial year or with a turnover of at least Rs 250 crore for the preceding financial year shall not exceed Rs 25 crore, for a period of up to ten years from the y (being the number of years for which an entity can be recognized as a start-up).
Current Situation
The income tax department has notified a large number of start-ups that they must pay up to 30% of their funding as angel tax. Many angels have received notices requiring them to disclose their source of income, bank statements, and other documents. This has sparked outrage among startup founders and angel investors.
The government has stated that no coercive measures will be used to collect this tax. It has formed a committee to investigate this matter. Some of the conditions for new businesses have already been relaxed. Currently, start-ups formed prior to April 2016 are eligible for angel tax exemption if their total paid-up share capital and share premium do not exceed Rs 10 crore.
FAQ on Angel Tax in India
Here are answers to some frequently asked questions about angel tax in India:
Q : What is angel tax?
Angel tax is a tax levied on the capital raised by startups from angel investors, where the valuation of the company exceeds its fair market value. This tax is levied at the rate of 30% on the amount of capital raised that exceeds the fair market value.
Q: Why is angel tax controversial in India?
Angel tax is controversial in India because it can be applied retroactively, which means that startups that have already raised funding from angel investors may be required to pay the tax on that funding, even if it was raised several years ago. This can be a significant financial burden for startups, and has led to concerns among investors and the startup community.
Q: Are there any exemptions to angel tax in India?
Yes, the Indian government has recently introduced a number of exemptions to angel tax for startups. These include exemptions for startups that are recognized by the government, as well as exemptions for startups that have raised funding from certain recognized investors.
Q: How can startups avoid angel tax in India?
To avoid angel tax, startups can apply for recognition from the government, or raise funding from investors who are recognized by the government. They can also ensure that the valuation of their company is in line with the fair market value, as determined by the government.
Q: What is the future of angel tax in India?
The future of angel tax in India is uncertain, as there have been calls for its repeal from investors and the startup community. The government has also introduced a number of exemptions and clarifications in recent years, which may indicate a shift in its approach to the tax. However, it is not yet clear what the ultimate fate of angel tax will be in India.
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