What is Angel Tax?

Angel tax is a well-known term in the Indian start-up ecosystem. Angel tax is the income tax imposed on Indian start-ups that receive funding from angel investors exceeding the fair market value of the company. The excess investment amount is subject to angel tax. This article offers a comprehensive guide on what is angel tax, covering everything from the applicable tax rates to exemptions and drawbacks.

Angel tax means the income tax applicable on unlisted companies for raising capital from angel investors through the issue of shares. Start-ups can leverage their strong brand value and future growth expectations to issue shares at a higher price than a comparable stock. Indian start-ups are liable to pay an angel tax if the funding amount is above the company’s fair market value or FMV. In other words, angel tax is levied if the unlisted start-up has issued shares to an Indian investor at prices above the company’s fair value. The funds that exceed the fair market value of the company are categorised as ‘income from other sources’ and taxed accordingly. For instance, if a company’s fair market value is Rs. 2 Crore and it raises Rs. 2.5 Crore from angel investors then the excess amount of Rs. 50 Lakhs is subject to taxation.

It is important to note that angel tax is no longer applicable in India. Budget 2024 abolished angel tax in India. In other words, companies raising capital from 1st April 2024 onwards will not be liable to pay the angel tax.

Understanding the origins of angel tax will help clarify the meaning and purpose of this tax. The idea for angel tax was first introduced in the Union Budget of 2012 by the then Finance Minister, Mr. Pranab Mukherjee. Angel tax was primarily introduced to tackle issues of money laundering in the country. The Finance Act of 2012 introduced section 56(2)(viib) to the Income Tax Act of 1961 outlining the provisions for taxing any investment received by an unlisted Indian company that exceeds the fair market value of its shares.

Start-ups strongly opposed the imposition of angel tax since it increased their tax liabilities. They claim that the imposition of the tax creates cash flow restraints for the company since it relies on funds to fuel its growth and development. Imposition of the angel tax takes funds away from the raised capital, hindering growth and expansion plans. A portion of the funds raised now have to be directed towards tax compliance, potentially limiting innovation and growth.

According to the angel tax norms, the tax is levied on the fair market valuation of the start-up in question. The methodology used to compute the fair market value of a company has also remained a bone of contention between the start-ups and the IT Department. The IT Department calculates this fair market value on the basis of the net assets of the company. However, start-ups argue that factoring in the estimated future growth prospects of the company are equally essential. When growth prospects for the future are factored in, the valuation automatically rises, lowering excesses. This difference in calculation methodologies results in hefty tax payments by start-ups.

Some start-ups claimed to have received tax notices for angel investments raised over 3 years ago. In certain cases, the tax amount plus late fee charges were even higher than the total funding amount. Additionally, start-ups pointed out that the existence of angel tax in India puts them at a competitive disadvantage over their global counterparts where foreign start-ups are not required to pay such taxes. In short, angel tax was seen as an impediment to the Indian start-up ecosystem.

Since its inception, angel tax was only applicable for domestic investors. However, Budget 2023 changed the applicability scope of the tax. From 2023 onwards, angel tax was applicable on investments made by resident investors as well as foreign investors. In other words, shares of unlisted Indian companies issued to foreign investors above the FMV will also be taxable.

The 2019 Union Budget introduced certain exemptions u/s 56(2)(viiib) offering some relief to Indian start-up founders, entrepreneurs, and investors. The budget stated that if a start-up is registered with the Department for Promotion of Industry and Internal Trade (DPIIT), it would not be subject to angel tax. However, to become eligible for DPIIT, the start-up needs to submit an application with all necessary documents and returns to the CBDT (Central Board of Direct Taxes). They will be exempted from angel tax payments only if this application is approved by the CBDT.

According to the exemption regulations, start-ups need to meet the following parameters to qualify for an angel tax exemption:

• After share issuance, the paid-up capital, along with the premium on shares, should not exceed Rs. 25 Crores.
• The fair market value of the start-up must be certified by a merchant banker.
• The investor should have a minimum net worth of Rs. 2 Crores and the individual's average income should not be less than Rs. 50 Lakhs in the last 3 years.
• The start-up must have a yearly turn-over of less than Rs. 100 Crore in the past fiscal years.
• The start-up should receive approval from an 8-member inter-ministerial board for the angel tax exemption.

The government later eliminated the merchant banker evaluation and 8-member inter-ministerial board approval to simplify the exemption claiming process.

Now that you know what is angel tax, you must be wondering about the corresponding taxation rates. Angel tax is levied at a rate of 30.9% on investments received by a start-up in excess of its fair market value. Angel tax in India is a uniform and flat rate, applicable to eligible start-ups.

The imposition of angel tax was strongly opposed by the start-up community due to the following drawbacks:

• Start-ups lose a significant portion of the raised capital to meet tax compliance requirements. This takes away funds that could be better utilised to pursue growth and innovation.
• Angel tax can make start-up funding and angel investments less appealing, potentially limiting innovation and entrepreneurship.
• The extension of angel tax to foreign investors in 2023 also raised concerns about a potential decline in foreign investments.

Angel tax can create cash flow problems for start-ups since they have to pay the tax upfront, even if they have not generated sizable revenue.

Let’s take an example to better understand what is angel tax and how it is calculated. Let’s assume, start-up XYZ issues 50,000 shares to domestic investors at Rs. 3,000 per share to raise a total of Rs. 15 Crores as capital to fund its growth operations. The fair market value of the company is equal to Rs. 2,000 per share, which makes the fair market valuation of the issued shares equal to Rs. 10 Crores. If that’s the case, company XYZ will have to pay 30.9% angel tax on the excess amount of Rs. 5 Crore (the amount exceeding its fair market value). In other words, start-up XYZ now has to pay an effective angel tax of Rs. 1.54 Crores (30.9% of Rs. 5 Crores).

Angel tax has remained a major point of contention in the otherwise thriving Indian start-up ecosystem. While the tax aimed to curb money laundering and fair valuation, it also created hurdles for start-up investment. Many start-ups argue that angel tax essentially stiffs innovation and growth, creates valuation differences, and long-drawn tax issues. Even after the introduction of exemptions, this tax has faced severe backlash from start-up founders and entrepreneurs. Budget 2024 finally abolished the angel tax. Effective from FY 2025-2026, Indian start-ups do not need to pay any angel tax. This decision is expected to boost funding, attract foreign investment, and reduce compliance burdens, helping foster an environment where start-ups truly thrive.

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