Angel Taxation for startup in India

Introduction:

Angel Taxation for Startup in India, as per the Income Tax Act, refers to the tax imposed on the funds raised by startups from angel investors or other external sources, which are considered as “fair market value” by the Income Tax Department.

The primary objective of this provision is to prevent startups from raising capital through issuing shares at a premium price, which could potentially be used for tax evasion purposes. However, it has been a matter of concern for the startup ecosystem in India, as it sometimes leads to genuine investments being mistakenly considered as “income from other sources” and taxed accordingly.

Section: This tax is levied under Section 56(2)(vii) (b) of the Income Tax Act, 1961.

What is the Applicability of Angel Tax?

Tax is levied only on the premium amount received by the company. In simple words, the difference between the face value of the shares issued and the actual value of the shares is calculated and taxed at the applicable rate.

Example:

Suppose A Ltd. and B Ltd. manufacture pens and sell them at ₹20 and ₹8, respectively. The cost of manufacturing a pen is ₹10. Now, A Ltd. is a renowned brand, and people are willing to purchase its product even after paying ₹20.

The extra ₹10 that people are willing to pay for the pen of A Ltd. is the premium amount or the extra amount earned by the company.

What are the changes in Angel Tax for Budget 2023?

Budget 2023 proposes that shares being issued to non-resident investors over and above FMV will be covered by the aforesaid provision of taxability. Moreover, benefit of exemption from the ‘Angel Tax’ provided to domestic investors of eligible start-ups has not been extended to non-resident investors as yet.

What are Angel Tax Exemptions?

Earlier, the consideration received in the form of angel investment was chargeable to tax under section 56(2) (viib) under the ‘Income from Other Sources’ head. However, the Indian government brought about exemptions in Angel Tax for start-ups in 2019 to encourage ease of doing business. Start-ups are now exempt from paying angel tax subject to the following conditions –

• The Department for Promotion of Industry and Internal Trade (DPIIT) should recognize the start-up.
• The total paid-up capital of the start-up should be less than or equal to 25 crores. However, the calculation of the paid-up capital shall not include the consideration received in respect of shares issued to a non-resident, a venture capital fund and a venture capital company.
• A certified merchant valuer must value the start-up and find its fair market value.
• The start-up must receive angel investment from foreign investors and not resident investors.
• The start-up should not invest in any of the following within 7 years of issuing the shares –
• Building or land
• Advancing loans
• Capital contribution to any other entity
• Any mode of transport costing more than 10 lakhs
• Jewellery
• Archaeological collections and Shares and securities.

What are the Rates of Angel Tax in India?

The angel tax is levied at the rate of 30% in India, and an additional cess of 3% is also applicable to it as per section 56(2)(vii)(b) of the Income Tax Act, 1961. The effective rate of the angel tax is 30.9%.

Which start-ups are exempt from Angel Tax in India?

Start-ups having a paid-up capital of not more than 25 crores and recognized by the DPIIT (Department for Promotion of Industry and Internal Trade) are exempt from paying angel tax.

Who are Angel Investors?

Angel investors are rich individuals who invest in start-ups and small unlisted companies in exchange for equity shares or ownership of the company.

When was the Angel tax introduced in India?

The Finance Act of 2012 first introduced the Angel Tax concept in India, which became applicable in April 2013. The Income Tax Act keeps updating the provisions related to Angel Tax. Budget 2023-24 expanded its scope to include foreign investors “to eliminate the possibility of tax avoidance.

Benefits of Angel Taxation:

Here are some potential benefits associated with angel taxation:

• Tax Credits or Deductions: Some jurisdictions offer tax credits or deductions to angel investors as an incentive to invest in start-ups. These incentives can help reduce the overall tax liability of the investor.
• Capital Gains Tax Treatment: In certain cases, angel investors may benefit from favourable capital gains tax treatment. This could involve lower tax rates on the capital gains generated from the sale of their equity in a start-up.
• Loss Deductions: In some jurisdictions, angel investors may be eligible for deductions on their taxes in case the start-up they invested in fails. This can help offset losses incurred from unsuccessful investments.
• Economic Development Incentives: Governments may view angel investors as contributors to economic development and employment. As a result, they may provide tax incentives to encourage angel investment, which, in turn, supports the growth of innovative businesses.
• Carry forward of Losses: Some tax systems allow investors to carry forward losses from unsuccessful investments to offset future capital gains, reducing their overall tax liability.
• Seed Enterprise Investment Scheme (SEIS) or equivalent: In certain countries like the United Kingdom, there are specific schemes like SEIS that provide tax reliefs for individuals investing in early-stage companies, making it more attractive for angel investors.

Disadvantages of Angel taxation:

• High Risk: Investing in start-ups is inherently risky, as many start-ups fail to become profitable or sustainable. Angel investors face the risk of losing their entire investment if the start-up they’ve invested in does not succeed.
• Illiquidity: Investments in start-ups are often illiquid, meaning that it may take a long time before investors can realize any returns. Unlike publicly traded stocks, selling equity in a private start-up can be a complex and time-consuming process.
• Lack of Diversification: Angel investors typically invest in a small number of start-ups, and their portfolios may lack diversification. This concentration of investments increases the risk, as the failure of a single start-up can have a significant impact on the overall portfolio.
• Limited Control: Angel investors often hold a minority stake in the start-ups they invest in, limiting their control and influence over the company’s decisions. This lack of control can be a disadvantage if the start-up’s management makes decisions that the investor disagrees with.
• Long Time to Exit: Even if a start-up becomes successful, the time it takes for an exit event (such as an acquisition or initial public offering) can be many years. Angel investors may need to wait a long time before they can realize any returns on their investment.
• Market Volatility: The start-up ecosystem can be highly volatile, influenced by factors such as changes in market trends, economic conditions, and technological advancements. This volatility can impact the success of start-ups and, consequently, the returns for angel investors.
• Due Diligence Challenges: Conducting thorough due diligence on start-ups can be challenging, especially for individual angel investors who may not have the resources or expertise of larger investment firms. This increases the risk of making poor investment decisions.
• Legal and Regulatory Risks: Legal and regulatory compliance can be complex in the start-up ecosystem. Angel investors may face challenges navigating these regulations, and changes in laws or regulations can impact the investment landscape.