Angel Tax and its implication on startups in India

Background

India ranks as the third largest global hub for startups. In 2014, the Government introduced the “Startup India” initiative with the aim of supporting and fostering startup growth, thereby boosting the Indian economy, promoting innovation, and creating employment opportunities. Startups differ from regular companies, partnerships, or limited liability partnership firms due to their unique characteristics. To qualify as a startup, an entity must meet the eligibility criteria outlined in the latest notification issued by the Department for Promotion of Industry and Internal Trade (DPIIT).

However, despite the Government’s efforts to create a conducive environment for startups, there are several persistent challenges that hinder their growth. One such challenge is the controversial “angel tax,” which has become a cause of distress for startups and has a negative impact on the current startup ecosystem in India. The entrepreneurial community strongly opposes this tax and views it as a major obstacle.

In an effort to provide relief measures and exemptions to encourage investment in startups, the government implemented the Startup India scheme. As part of this initiative, a notification was issued on April 11, 2018[1], outlining the procedure for granting exemption from section 56(2)(viib) of the Act to certain eligible startups. Subsequently, on January 16, 2019, the government issued another notification[2] to further ease some of the conditions for claiming this exemption.

However, concerns regarding the applicability of this provision persisted among start-up businesses. These concerns included potential misuse of provisions by tax authorities during assessments on start-ups. As a result, several representations were made to the Government.

In response, the Ministry of Commerce and Industry issued a new notification on 19th February 2019[3], replacing the previous notifications. This new notification expanded the definition of start-ups and further relaxed certain provisions for their benefit.

The notification will apply to all start-ups, regardless of the dates on which shares are issued, from the date of their incorporation. However, shares issued prior to this notification date, and on which an addition under section 56(2)(viib) of the Act has been made, are exempted.

The issue of angel tax gained significant attention within the Indian startup community when it was revealed that the Income Tax Department withdrew over Rs. 1 crore from the bank accounts of two startups, Travelkhana and Babygogo,[4] without prior notice. However, the recent notification issued by the DPIIT on 19th February 2019 has provided some relief to eligible startups by granting them tax exemption.

CONCEPT OF ANGEL TAX

Angel Tax, officially known as Section 56 (2) (vii b) of the Income Tax Act, imposes a tax on the funds raised by startups if the amount exceeds the fair market value of the company. It was introduced in 2012 by the UPA government with the aim of detecting money laundering practices and identifying fraudulent startups.

To put it simply, Section 56(2)(viib) of the Act states that if a company, in which the general public is not significantly interested, issues shares at a premium, the amount by which the share issue price exceeds the fair market value of those shares, calculated according to the prescribed methodology, will be subject to income tax.

In 2022, over 2,000 startups nationwide received notices to settle their angel tax liabilities, and some of them faced significant penalties for failing to promptly pay the tax. Moreover, the tax department has been demanding unnecessary documents, further complicating the situation for startups.

Recently, the Indian government introduced new tax laws aimed at promoting the growth of startups in the country. These measures include an angel tax exemption, which has brought about a positive change in the regulatory environment. They provide relief and encouragement to both entrepreneurs and angel investors. This article examines the impact of the recent tax laws in India on the startup ecosystem, with a particular emphasis on the significance of angel tax exemption.

STEPS TAKEN BY THE INDIAN GOVERNMENT TOWARDS DEVELOPMENT OF THE ANGEL TAX REGIME

Angel Tax Exemption

Recognizing the importance of creating a conducive environment for startups, the Indian government has taken measures to alleviate the burden of angel tax and foster growth in the sector. These modifications were implemented through amendments to the Finance Act and the introduction of a Notification on April 11, 2018, which was subsequently amended on February 19, 2019. The key highlights[5] of the 2019 notification are as follows:

1. Increased Threshold: The threshold limit for startups eligible for angel tax exemption has been raised from INR 10 Crore (as stated in the 2018 notification) to INR 25 crore. This revision expands the pool of startups that qualify for the exemption, enabling them to attract larger investments without concerns about angel tax implications. The higher threshold allows more early-stage ventures to benefit from the exemption, facilitating their growth. Additionally, when computing the aggregate amount of paid-up share capital and share premium of INR 250 million, the shares issued to non-residents, venture capital companies or funds registered as Category I AIFs, and specified companies are excluded.
2. Eligibility Criteria: Startups must meet specific eligibility criteria to qualify for angel tax exemption. They must be registered as a company under the Companies Act, 2013, and have been incorporated for less than 10 years (previously 7 years as per the 2018 notification, or 10 years for startups in the Biotechnology sector). Moreover, the startup’s annual turnover should not exceed INR 100 crore in any previous year (compared to the previous limit of Rs. 25 crores). Startups meeting these criteria can avail the angel tax exemption and focus on their growth without the burden of tax-related concerns.
3. Certified Valuation: Startups seeking angel tax exemption must obtain a certified valuation from a merchant registered with the Securities and Exchange Board of India (SEBI). This valuation, along with other necessary documents, must be submitted to the Central Board of Direct Taxes (CBDT) for assessment. The certified valuation ensures transparency and credibility in determining the fair market value of the startup.
4. Angel Investors: The angel tax exemption also provides relief for angel investors. Previously, investors had to ensure that their net worth exceeded the investment amount; otherwise, their investments were subject to scrutiny. The recent changes have eliminated this requirement, offering angel investors greater flexibility. This change encourages more angel investors to support startups and contribute to their growth without unnecessary scrutiny.
5. Restriction on investments by start-ups: The start-up should not have invested in any of the following assets:

• Building or land appurtenant thereto, being a residential house, other than that used by the startup for the purposes of renting or held by it as stock-in-trade, in the ordinary course of business;
• Land or building, or both, not being a residential house, other than that occupied by the start-up for its business or used by it for renting purpose or held by it as stock-in trade, in the ordinary course of business;
• Loans and advances, other than loans or advances extended in the ordinary course of business by the start-up where the lending of money is a substantial part of its business;
• Capital contribution made to any other entity;
• Shares and securities;
• A motor vehicle, aircraft, yacht or any other mode of transport, the actual cost of which exceeds INR 1 million, other than that held by the start-up for the purpose of plying, hiring, leasing or as stock-in-trade, in the ordinary course of business;
• Jewellery other than that held by the start-up as stock-in-trade in the ordinary course of business;
• Any other asset, whether in the nature of capital asset or otherwise, of the nature specified in sub-clauses (iv) to (ix) of clause (d) of Explanation to clause (vii) of sub-section (2) of section 56 of the Act i.e., Archaeological collections, Drawings, Paintings, Sculptures, any work of Art or Bullion.

6. Requirement of report from merchant banker: There exists no requirement to obtain a valuation report as per the new notification.
7. Procedure of application: A start-up recognised by DPIIT and fulfilling the conditions mentioned for exemption under section 56(2)(viib) of the Act, shall file a duly signed declaration in Form-2 to the DPIIT. On receipt of such declaration, the DPIIT shall forward it to the CBDT. No approval from the CBDT which was earlier reqired under the 2018 notification is now required under the new notification.

Proposals under Budget 2023-24

Moreover, in the recently unveiled Budget 2023-24, the government has put forth a proposal to broaden the scope of the ‘angel tax’ to encompass transactions involving foreign investors. This pertains to the additional payment received as a premium. If an Indian company that is not publicly listed receives an excessive premium upon selling shares to a foreign investor, the surplus premium is classified as “income from other sources” and will be subject to taxation. Prior to this proposal in the 2023-24 budget, angel tax was only applicable to investments made by resident investors.

In simpler terms, the bill suggests extending the angel tax provision to cover the extra consideration received by privately owned companies when issuing shares to non-resident shareholders. The amendment will take effect starting from the financial year 2023-24. Considering that the current form of the provision has limited exceptions (where the exemption granted to designated start-ups is subject to restrictive conditions), if this proposal is enacted, it could have a negative impact on privately held companies seeking to secure capital at a premium from non-resident investors. This change will bring foreign investors within the purview of taxation. Therefore, when a start-up acquires funding from a foreign investor, it will also be considered as income and become taxable following the amendment.

The new framework will undoubtedly bring about a more convenient life for start-up companies, who are in a dire need of funds to support their expansion and meet other business needs. These modifications will incentivize affluent individuals to invest in startups that secure funding at a higher rate due to their ground breaking business model, even if the value is not solely based on tangible assets they possess. Moreover, as the new regulations apply retroactively, numerous young companies that previously received notices from the Income Tax Department will find solace in the recent adjustment to the rules.

POSSIBLE IMPACTS OF THE NEW ANGEL TAX MECHANISM

1. If the proposed amendment is approved, it would have implications from a tax law perspective, affecting shares issued to both resident and non-resident investors. However, there is a distinction for shares issued to non-resident investors as they must also adhere to valuation requirements outlined in foreign exchange management Act (FEMA). The proposed amendment, if passed, could potentially clash with the valuation standards set by FEMA regulations, thereby impacting the ability of Public Limited Companies to secure capital from non-resident investors.

According to FEMA regulations, shares must be issued to non-residents based on their fair market value (FMV) at the very least price. Consequently, while the angel tax provision sets a maximum value beyond which adverse tax consequences may arise for the issuing company, FEMA regulations establish a minimum price. As a result, the angel tax provision and FEMA pricing requirements appear to be conflicting with each other. In such a situation, to ensure that there are no adverse effects under the angel tax provision or FEMA regulations, the company would seemingly be compelled to issue shares precisely at the FMV. This approach is excessively restrictive and may not be commercially viable.[6]

2. In order for a startup to qualify for tax exemption, it is necessary for them to refrain from investing in stocks and securities. Many startup ventures often choose to invest their received funds in debt mutual funds, which are a commonly used investment instrument for startups. Additionally, startups are required to avoid making capital contributions to any entity in order to be eligible for the exemption. This means that if a startup has a subsidiary, associated firm, or associated ventures, they will be disqualified from claiming tax exemptions as stated in the notification. Unfortunately, this discourages the healthy growth of startups within a business ecosystem.
3. Companies must be officially registered as start-ups with the government in order to take advantage of the latest exemption and to be recognized as a start-up, a company must fulfill specific requirements as discussed above.
4. The 2019 notification poses a significant challenge for startups that have already received assessment orders. According to Paragraph 6 of the notification, these startups are not eligible for the exemption outlined in the notification. This aspect represents a major drawback of the notification, as it contradicts the original purpose for its issuance. Nevertheless, the Central Board of Direct Taxes (CBDT) has clarified that the matter of granting exemption to startups with existing assessment orders can only be resolved through the appeals process.
5. These notifications, which are primarily implemented to prevent money laundering, can result in significant bureaucratic delays and encourage corrupt behaviours.
6. The new regulations concerning angel tax, although less stringent than before, can still create issues by leading to arbitrary tax demands for companies that do not fall within the defined start-up category.
7. The amount of taxes owed is calculated based on the difference between the sale price of a company’s unlisted shares and their fair market value.
8. Since it is not possible to determine the market value of shares that are not openly traded, tax authorities with questionable intentions can still find excuses to harass start-ups by making unreasonable tax demands. The negative impact on investor confidence will persist unless the government addresses the arbitrary nature of this angel tax.

The changes, when seen in totality, are welcome, for startup companies. The changes will also assuage the government’s concerns to a small extent with respect to shell companies evading taxes under this mechanism, while permitting exemptions for startup organisations.

CONCLUSION

To summarize, going forward, non-resident investors and publicly listed companies should carefully evaluate the interaction between tax laws and FEMA regulations for conversion and share issuance transactions. It is crucial for both investors and privately held companies to obtain comprehensive valuation reports based on justifiable assumptions and projections, considering both tax and FEMA regulations.

Considering the complexities and factors mentioned above, it is anticipated that the proposed amendment will be reconsidered. If enacted, this provision is likely to have a negative impact on foreign direct investment in India, which is clearly undesirable at this time. There are indications that the income tax department intends to introduce modified valuation rules under the ITA to address the conflict between valuation under tax law and FEMA provisions. The implications and effects of these modified tax valuation rules will need to be assessed upon the introduction of the amendment.

However, the 2019 notification reflects the Government’s ongoing focus on providing relief to start-ups. The shift from an approval-based system to a declaration-based system for start-up registrations simplifies the process and demonstrates a trust-based approach. While certain concerns remain, such as the denial of benefits for start-ups that have already received demand notices and the lack of exemption for certain categories of AIFs regarding fund investments, this notification should significantly benefit the overall start-up investment ecosystem.

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[1] DIPP Notification No. G.S.R. 364(E) dated 11 April, 2018.

[2] DIPP Notification No. G.S.R. 34(E) dated 16 January, 2019.

[3] DPIIT Notification No. G.S.R. 127(E) dated 19 February, 2019.

[4] Sanket Vijayasarathy, Angel Tax Bites Travelkhana And Babygogo, IT Dept. Forcefully Withdraws Rs. 1 crore from their Bank Accounts, available at <https://www.indiatoday.in/technology/news/story/angel-tax-bites-travelkhana-and-babygogo-it-dept-forcefully- withdraws-rs-1-crore-from-their-bank-accounts-1452048-2019-02-09> (last visited 19 May 2023).

[5] Parul Aggarwal, Relaxed Norms on Angel Tax — An Inadequate Offering, [2019] 102 taxmann.com 140.

[6] Budget 2023: Angel tax on share consideration received from non-resident investors, available at https://trilegal.com/wp-content/uploads/2023/02/Trilegal-Update_Budget-2023_Angel-tax-on-share-consideration-received-from-non-resident-investors-1.pdf (Last visited 20 May 2023).