Angel Tax In India: Everything You Need To Know

More commonly called as Angel Tax in the start-up world, it is the tax levied under Section 56(2)(viib)  of the Income Tax Act 1961 (“the Act”), on the capital raised by privately held companies via the issue of shares to a resident, the consideration for which exceeds the face value and the Fair Market Value (FMV) of the shares issued. Angel tax gets its name from the wealthy individuals (“angels”) who invest heavily in risky, unproven business ventures and start-ups, in the initial stages when they are yet to be recognised widely.

Rationale Behind Introducing Angel Tax

The whole thrust for such taxation is to bring measures to tax the excessive share premium received over and above the FMV by private companies, which was extensively being used as a mechanism for accounting for hitherto unaccounted money and to receive corporate kickbacks. In essence, this is one of the anti-abuse provisions introduced to prevent money laundering.

Angel Tax and Start-ups

According to a joint survey by LocalCircles and the Indian Venture Capital Association, nearly 73 per cent of the start-ups received one or more Angel Tax notices. Later based on representations and because in the startup ecosystem shares are issued at a premium and value the long term potential of the company which may not be captured under the valuation methodology specified (Net Asset Value – NAV) under this section, an exemption was provided to start-ups recognised by the Department for Promotion of Industry and Internal Trade. However, the exemption was provided subject to the following specified conditions:-

Start-ups should not invest, within 7 years from the end of the latest financial year in which the shares are issued at a premium, in

o Land or buildings (except for own use),

o Shares and securities,

o Capital of other entities,

o Jewellery and artifacts,

o Any mode of transport where the actual cost exceeds Rs 10 lakh, other than in a normal, ordinary course of business.

No loans and advances should be extended, unless lending is in ordinary course of business, within the aforesaid 7 years.

Further, the aggregate amount of paid-up share capital and share premium of the start-up post issue of shares, excluding such amount, as raised from non-residents, Venture Capital Company (“VCC”) or Venture Capital Fund (“VCF”), or a specified listed company with net worth of at least Rs 100 crore as on last day of preceding financial year or with a turnover of at least Rs 250 crore for the preceding financial year, shall not exceed Rs 25 crore, up to 10 years from the year of incorporation (being the number of years for which an entity can be recognized as a start-up).

Angel Tax - A Cause for Concern for Start-ups?

The number of start-ups eligible for the exemption from angel tax saw an increase from 1867 as of December 31, 2019, to 3,612 start-ups as of February 3, 2021. Despite the 93.4 per cent jump, this exemption which was intended as a breather to start-ups, turned out to be a dampener due to the following reasons:-

Start-ups invest the surplus funds raised in debt mutual funds to multiply their funds. A blanket restriction on investment in shares and securities hampers the investment and growth opportunities of start-ups.

Start-ups give salary advances or loans to employees and these start-ups are now not eligible for the exemption from angel tax. This embargo on loans and advances, without any threshold limit, is far too constraining.

Start-ups are barred from making a capital contribution to any other entity. This again creates obstacles for companies, looking to expand their operations through mergers and acquisitions or setting up subsidiaries. Further, those start-ups that operate in sectors that require liaisons (fintech, e-commerce) with other firms to sustain long-term growth are also burdened. It is now the new normal among start-ups to merge and/or acquire, as is evident from the cases of Zomato and Uber Eats & Byju’s and White Hat Jr, amongst other acquisitions.

As per a Nasscom-Zinnov report, Indian start-ups take an average of 6-8 years, to reach a $1 billion valuation. Start-ups like Ola, Udaan, and Glance have attained unicorn status in about 2.4 years. Given the need to fast-pace the growth of Indian start-ups, a 7-year restriction on down-stream investments seems unaccommodating.

Most importantly, the restrictions on the deployment of funds are not limited only to the money raised from the angel tax investors but a blanket restriction on all these activities for 7 years. In other words, start-ups are prohibited from such investments/deployment even out of the capital raised subsequently from VCCs, VCFs or any other nonresidents for 7 years, which are excluded from the threshold of Rs 25 crore mentioned supra.

The failure to satisfy any of the conditions for 7 years would result in the excess consideration (share premium less FMV) being treated as income of start-ups. The consequential penalty of a whopping 200 per cent penalty on such an amount under Section 270A of the Act, seems draconian for exploring further developmental opportunities and effectively, a penalty on growth. 

Recent Trends

Over the last five years, India has seen an inflow of $250 billion of foreign direct investment. Out of the total, almost 75 per cent of this FDI, i.e. $184 billion, has come in through venture capital and private equity funding, which invests in the unlisted companies, start-ups, and growth companies, leading to the creation of unicorns. While this unprecedented surge in FDI can partly be viewed as a means to avoid any implication of angel tax (because of the restrictive covenants), it can additionally be attributed to the liberalised regulatory environment for foreign investments in start-ups and the promising business models of young Indian entrepreneurs. Sequoia Capital, Japan’s SoftBank Group Corp., and U.K.’s Steady Capital are some of the top investors in the Indian start-up unicorn story. The impact of the investment by the non-resident investors is that the majority of these start-ups are forced to have their holding company outside India, to limit the exposure to the Indian laws.

Way Forward

As of May 2021, there are over 50 unicorn start-ups in India, with valuations exceeding $1 billion (approx. Rs 7200 crore). It is pertinent to note that recently, the 4-year old start-up Groww is all set to acquire 14-year old Indiabulls Mutual Funds. The success story of some of the startup unicorns of fund-raising might overshadow the issue but in the initial stages of the startups, it’s the resident investors who invest in and help them in graduating to the next level, whereafter, the Venture Capital investors and private equity investors storm into the limelight with their big bang investments.

Even though the intent of the government to prevent misuse and abuse of the provisions is understandable, relaxation of certain conditions and bringing the timeline down would go a long way in ensuring that the genuine start-ups are not affected by the regulations and could lead to many more success stories. The following relaxations may be considered:

- Restriction on end-use to be restricted only to the funds raised from the angel tax investors instead of a blanket restriction

- Reduction of the time limit from 7 years to 3 years especially for certain conditions like that of investment in the capital of other entities

- The monetary limit of Rs 25 crore can be extended to Rs 50 crore or Rs 75 crore

- Valuation method based on future earnings such as DCF instead of NAV for recognised start-ups

These steps would help the start-ups in a big way and resident angel tax investors, which are currently subject to angel tax, can also enjoy a pie out of the success of the Indian start-ups with more investment opportunities.

The author is the Founder and Managing Partner of DVS Advisors LLP

 DISCLAIMER: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.