Every business needs money to run. In an early-stage venture, the product or service might still be in development to start a company, or the revenue generated is insufficient to finance the day-to-day operations and plan for future developments. In this scenario, startups seek investments in exchange for equity as they do not have tangible items to offer a bank as collateral. An Angel Investor steps in and invests money in a startup while it is still finding its feet and is struggling to establish itself in the marketplace.
What is Angel Tax?
Angel tax was introduced to curb money laundering. The finance bill of 2012 gave genesis to section (56(2)(viib)) of the Income Tax Act. It dealt with investments received by an unlisted Indian company, i.e., a company whose shares were not available for purchase by the public on the stock market. Under this law, the portion of the investment over the fair market value was considered income from other sources.
Who Must Pay Angel Tax?
The startups that raise money from resident Indian investors must pay angel tax. The capital raised above the fair market value is taxed at 30.9%. This hefty tax rate raised quite a few eyebrows when it was introduced, and it continues to be a source of pain.
What are the Exemptions from Angel Tax?
After much pleading by the startups, the Indian government introduced a few relaxations in the 2019 union budget. After the issue of shares, the aggregate amount of paid-up share capital and share premium of the Startup cannot be more than ₹25 crores.
The amount raised from Non-Resident Indians (NRIs), Venture Capital Firms, and specified companies is not included in the calculation. The startup annual turnover should not have exceeded ₹100 crores in any of the previous fiscal years.
While a business is considered a Startup for 10 years, from the date of incorporation, it can avail a tax holiday for only 3 consecutive years in that period.
Startups that have been recognised by the Department for Promotion of Industry and Internal Trade can forward their application to the Central Board of Direct Taxes. If approved by CBDT, they are exempted from paying angel tax.
For angel investors, the amount of investment that exceeds the fair market value can be claimed for a 100% tax exemption. However, the investor must have a net worth of ₹2 crores or an income of more than ₹25 Lakh in the past 3 fiscal years.
Angel Tax: A Concern for Startups?
In 2021, private equity and venture capital firms invested a record-breaking $77 billion in unlisted Indian companies. 44 unicorns (companies that are valued at over $1 billion) were minted in the calendar year, taking the total tally to over 80 unicorns at the end of 2021. Most of this money is raised via Foreign Direct Investment (FDI) to avoid the payment of angel tax. Some start-ups even resort to incorporating outside India to escape angel tax, with Singapore favouring destinations. Resident Indian investors cannot benefit from the explosion of high-growth startups in the country, with foreign investors taking home the gains, thereby depriving the Indian economy of other further investments the money could have generated.
Under the Start-up India Action Plan, start-ups that meet the definition as prescribed under G.S.R. notification 127 (E) are eligible to apply for recognition under the program.
The Eligibility Criteria for Startup Recognition:
- 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 fiscal years.
- An entity shall be considered as a Start-up up to 10 years from the date of 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”.
Startup India: 80 IAC Tax exemption:
After getting recognition, a Startup may apply for Tax exemption under section 80 IAC of the Income Tax Act. Post getting clearance for Tax exemption, the Start-up can avail tax holiday for 3 consecutive fiscal years out of its first ten years since incorporation.
Eligibility Criteria for applying to Income Tax exemption (80IAC):
- The entity should be a recognised Startup.
- Only Private limited or a Limited Liability Partnership is eligible for tax exemption under Section 80IAC.
- The Start-up should have been incorporated after 1st April 2016.
However, the exemption is subject to the condition that the start-up does not invest in any of the following within 7 years of the end of the last fiscal year in which the shares are issued at a premium:
- The use of a building or land for a purpose (other than personal use or for stock in trade or as a rental property)
- To advance loans (other than when the lending of money constitutes the bulk of the business of a startup).
- Contribution of capital to another entity via stock or bonds
- Shares and Securities
- Motor Vehicle, aircraft, yacht, or any other mode of transport, the actual cost of which exceeds INR 10 Lakhs (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 the ordinary course of business)
- Archaeological collections & Artefacts etc.
Startup India: Tax Exemption under Section 56 of the Income Tax Act (Angel Tax)
After getting recognition, a Start-up may apply for Angel Tax Exemption.
Eligibility Criteria for Tax Exemption under Section 56 of the Income Tax Act:
- The entity should be a DPIIT recognised Startup.
- The aggregate amount of paid-up share capital and share premium of the Start-up after the proposed issue of a share, if any, does not exceed INR 25 Crore.
- The provisions outlined in Section 56 of the Income Tax Act, 1961 have caused concern among startups due to over-taxation of angel funds. Angel funds are taxed when received by a company. Entrepreneurs who formed their business before April 2016 can apply for exemptions from this section.
- In general, the tax relief applies to startups approved by the inter-ministerial panel, which have a paid-up capital and share premium of less than INR 10 crore after shares are issued. This notification is effective from 11th April 2018.
Note: Refer to the attached notification for details here.
The fact that Indian start-ups have managed to be so successful despite such restrictive laws is a testament to the tenacity and innovation of the sector. However, regulatory changes are necessary. Interested parties have been lobbying the government for quite some time to ease a few of the conditions.
Hopefully, we will soon see policy initiatives to aid faster growth and enable resident Indians to benefit from the success of startups.
About the Author
In a career spanning over four decades, CA Vinod Bansal has a diverse experience in the field of banking, FEX & Credit, investment, fund management, and business development. He is currently the President of CXO Genie, a platform connecting C-Suite Executives (CFOs, CHROs, Heads of Supply Chain, CEOs etc.) to find practical solutions and get advice on various challenges across various industry domains.