What is Angel Tax?
Introduced in 2012 Union Budget, was a tax provision which intended to curb money laundering but turned-out to be an entry barrier for start-ups and is now known as “Angel Tax”. This provision was applicable to closely held companies and the capital raised by them by issuing shares to external investors. The excess amount received by the startup than its fair market value through the funding process is considered as income and is taxed accordingly. This is Section 56 (2) (viib) of the Income Tax Act, 1961 in a nutshell.
The fair market value of shares is the higher of (a) the value computed in accordance to the income tax rules which accepts two valuation methods, the Net Asset Value method and the Discounted Cash Flow (determined by a merchant banker); and (b) the value substantiated by the company to the Assessing Officer based on the value of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature, on the date of issue of shares.
Various startups got slapped with notices from the income tax department seeking details on valuation and sources of funds. There were revaluations and the startups had to cough up 30% of the excess amount (as ascertained by the taxmen) of funding they received as Angel tax. This meant that there was a high possibility that, even after successful funding rounds, liquidity will still be an issue with nearly one third amount being paid as tax even before generating a single rupee in operational revenue from the funds to be deployed. Even after Startup India initiative, startups were suffering from tax issues. In some cases as reported in the media, even bank accounts of startups were frozen by taxmen and amounts withdrawn towards the angel tax liability. Though this was clarified as an error by the taxmen, there was no immediate relief for the affected startups.
The Current Scenario
The Start-up & Angel tax journey has come a long way since 2012. The GOI has taken several measures to ease out the pain endured by the start-ups and ensure that the tax provisions remain to arrest money laundering and doesn’t cause a collateral damage to the growth of Indian economy. The Start-up India scheme is one such initiative run under Department for Promotion of Industry & Internal Trade (DPIIT), Ministry of Commerce & Industry, Govt. of India. The Startup India scheme provides an array of benefits. One of them being exemption from the provisions of Section 56 (2) (viib). To understand it further, the definition of start-up/start-up recognition criteria under the scheme is critical and is as under;
- The Start-up should be incorporated as a private limited company or registered as a partnership firm or a limited liability partnership
- Turnover should be less than INR 100 Crores in any of the previous financial years
- An entity will be recognized as a start-up for a period of 10 years from its incorporation
- The Start-up should be working towards innovation/ improvement of existing products, services and processes and should have the potential to generate employment/ create wealth. An entity formed by splitting up or reconstruction of an existing business shall not be considered a “Startup”
Exemption from Section 56 (2) (viib) of the Income Tax Act
Exemption from angel tax is provided if;
- Start-up is recognized by DPIIT;
- Aggregate paid-up share capital and premium doesn’t exceed INR 25 Crores
- The threshold of INR 25 crores not to include funds raised by way of issuing shares to Non-Resident, VCC / VCF (Category I AIFs) and specified company
- It has not invested / will not invest for a period of seven years from the end of the latest financial year in which shares were issued at a premium, 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 Startup for its business or used by it for purposes of renting 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 Startup 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 ten lakh rupees, other than that held by the Startup 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 Startup 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.
Boost for Start-ups in Union Budget 2019
Finance Minister, Smt. Nirmala Sitharaman in her budget speech positively addressed the Angel Tax issue and provided certain reliefs as under;
- The start-ups and the investors who file requisite declarations and provide certain information in their returns will not be subject to scrutiny in respect of valuation of share premiums
- The investor identity issue and determining source of his funds will be resolved by e-verification mechanism which will end any other form of scrutiny by ITD
- Special administrative arrangements will be made by CBDT for pending assessment of start-ups and it will be ensured that no inquiry or verification in such cases can be carried out by the Assessing Officer without obtaining approval of his supervisory officer
- Start-ups are not required to justify fair market value of the shares if those are issued to Category I AIFs. This benefit is now extended to Category II AIFs which opens up more funding avenues
Has the Course Correction been initiated? The answer to this is Yes! With promising indicators from the 2019 budget, it is safer to say we are on the right path. We need to create a more favorable environment for start-ups in terms of much more relaxed and lean tax & labor laws with simplified compliance mechanisms to increase and retain foreign investments in India and compete with other nations which have more liberal policies and conducive environment for start-ups.