A sense of euphoria prevailed in the Indian start-up ecosystem as the Union Budget abolished the angel tax. Start-Up founders and VCs have congratulated and praised the government for the removal of the tax ever since it was announced.
In her Budget speech, Nirmala Sitharaman said, “To bolster the Indian start-up eco-system, boost the entrepreneurial spirit, and support innovation, I propose to abolish the so-called angel tax for all classes of investors.”
The Department for Promotion of Industry and Internal Trade (DPIIT), which had asked for the abolition of angel tax before the budget, has welcomed the move. The Secretary of DPIIT, Rajesh Kumar Singh, reportedly said that this move would help increase foreign investment.
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Before delving further, let's understand what an angel tax is and the consistent demand by start-ups for abolition of the same.
What is Angel Tax?
It is an income tax that is charged on start-ups or unlisted companies on the funding received by them when their valuation exceeds the fair market value. The tax falls under Section 56(2)(viib) of the Income Tax Act (ITA). It is charged at around 30 per cent. Since it mainly affects angel investors, it is referred to as angel tax.
It was introduced in 2012 by the Congress-led UPA government under then Finance Minister Pranab Mukherjee. The main point of introducing the tax was to prevent money laundering. In his Budget speech, Mukherjee said, “Taxation of unexplained money, credits, investments, expenditures, etc., at the highest rate of 30 percent irrespective of the slab of income.”
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For example, if an investor invests Rs 1 crore in a start-up at Rs 100 per share and the fair market value of the shares is Rs 50 each, subscribing to 1,00,000 shares, the Rs 50 lakh difference between the fair market value and the price paid is treated as taxable income, added Anisha Patnaik, Founder, Lexstart Partners & an angel investor. -
Just to simplify, the government suspected that some companies were disguising taxable income as share capital and premium to avoid paying taxes.
Valuing these shares can be subjective, leading to disputes between companies and tax authorities over what counts as excess share premium, said Abbas Jaorawala, Senior Director and Head Direct Tax, Khaitan Legal Associates.
How is it related to start-ups getting I-T notices?
In March this year, the Economic Times reported that start-ups have come under the scanner of the I-T department because of the fund raised by them.
The notices, issued under Section 68 of the Income Tax Act, combined the investments received by these start-ups with their earned income, resulting in taxes and penalties being imposed on the total amount.
Section 68 of the Income Tax Act mandates taxation on any unexplained credits, deposits, or investments in a company. The Finance Act, 2023, extended these angel tax provisions to cover investments by non-residents in unlisted Indian companies when such investments exceed the fair market value.
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In simple words, Angel Tax taxes funds received by unlisted companies from investors, while Section 68 mandates disclosure of the investor's source of funds. This ensures all funding, including legitimate investments, is scrutinized, as per experts.
With the aim to ease the burden of angel tax, in 2019, the Union Government announced that start-ups registered under the Department for Promotion of Industry and Internal Trade (DPIIT) would be exempted from the provision. To avail the exemption, a start-up had to send the necessary documents along with the application to the Central Board of Direct Taxes.
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What about the past cases?
While the industry has lauded the government for removing angel tax, a lingering question remains: what about the remaining cases? Mohandas Pai, partner at Aarin Capital, told Inc42 that the government should now dismiss all angel tax cases from the past five years and explicitly declare that no angel tax will be imposed on any ongoing assessments.
Speaking about the same, Jaorawala said that taxpayers involved in ongoing litigation on this issue for the past years would hope that the cases be settled in their favor. This would however require a specific amendment to the law or binding instructions issued to tax authorities to concede or not pursue these cases.
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Now that the angel tax has been abolished, what about having a check on money laundering? Abolition of angle tax does not necessarily indicate a rise in money laundering transactions through the issue of shares by closely held companies, as there are other provisions in the Income-tax Act, 1961, that safeguard such abuse, said Rahul Charkha, Partner, Economic Laws Practice.
The start-up ecosystem hopes that the move helps increase the funding. Start-Up funding fell to $7 billion in 2023 from $25 billion in funding that was received in 2022, marking a more than 70 percent downfall, as per data platform Tracxn. It will be interesting to see how the removal of angel tax will have an impact on the funding aspect of start-ups.
