Blog

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...