The Angel Tax Conundrum

WHAT IS ANGEL TAX?

The concept of angel tax was introduced to plug money laundering practices, by the former Finance Minister, Pranab Mukherjee, under the Finance Act, 2012. It refers to the income tax payable on the capital raised by unlisted companies via issue of shares where the share price exceeds fair market value (“FMV”) of the shares issued. The amount in excess of the FMV is treated as ‘income’ under the head ‘income from other sources’ as per the Income Tax Act, 1961 (“Act”) and is taxed in accordance with Section 56(2)(viib) of the Act.

Angel tax is charged on the difference between the price paid by the investor and the actual FMV of the shares. For example, if the FMV of a share is INR 20 and the price paid by the investor is INR 70, then tax will be payable on the difference, i.e., INR 50.

Interestingly, angel tax is levied only on investments made by resident investors. The investments made by non-resident investors in unlisted companies do not fall within the ambit of angel tax.

Additionally, exemption has also been provided to

a venture capital undertaking raising capital from a venture capital company, or a venture capital fund or a category I or category II alternate investment fund; and
a company, as may be notified by the central government in this behalf.

WHY IS IT A CAUSE OF CONCERN?

Investments in early stage companies are usually valued on future cash flows and potential of the venture rather than a present value of assets and liabilities. The investor expects the value of the such companies to rise exponentially in the future, and exceed the price paid by them. However, if a start- up is taxed on the investment amount, it loses the ability to utilise that invested money to reach its projected growth and value.

Further, since the amount is categorised as income, the tax rates are substantially high, in the range of 25% to 30%, depending on the turnover / gross receipts of the entity receiving the investment.

RELIEF TO START-UPS

Start-ups that have reached their Series A stage or growth stage (after Series A) are able to raise investments from marquee investors in the market. However, early stage start-ups intending to raise pre-seed or seed funding, have to rely on their family, friends and angel investors. It is for these early- stage start-ups that the angel tax specifically proves to be burdensome. Therefore, in an effort to reduce the tax burden on such early stage start-ups, the Department for Promotion of Industry and Internal Trade (“DPIIT”) has, by way of a notification[1], exempted certain start-ups which fulfil the following conditions :

The notification states that while calculating the aggregate share capital, investments made by the following categories of investors shall be excluded:

non-residents;
a venture capital company or a venture capital fund; and
company whose shares are frequently traded and whose net worth on the last date of financial year preceding the year in which shares are issued exceeds INR 100 crores or turnover for the financial year preceding the year in which shares are issued exceed INR 250 crore.

Further, in terms of the DPIIT Notification, an entity shall be considered as a start-up for a period of 10 years from the date of incorporation provided that it fulfils the following conditions:

From a procedural standpoint, the notification requires a start-up meeting the prescribed conditions to file a duly signed declaration in Form 2 to confirm the compliance with such conditions. On receipt of the declaration from the start-up, the DPIIT will forward to the declaration to the Central Board of Direct Taxes.

The exemption provided to start-ups under the notification is retrospective in nature. This means that even if an eligible start-up had issued shares at a price above its fair value prior to the date of the notification, such start-up can avail the benefits available under this notification by making an application for exemption, provided an assessment order levying tax on that particular issue of shares has not been issued.

The provision of angel taxation was amended by the Finance Act, 2019. As per the amendment, if a company fails to comply with any condition in pursuance of which it availed the exemption from the angel tax, then the consideration received by such company in excess of its fair value shall be considered as income and will be charged with tax for the previous year in which such failure takes place. It will also be considered as a non-compliance on the part of the company and invite penalties for misreporting its income under Section 270A(8) and 270A(9) of the Act.

IMPACT

Since the application of angel tax is only to domestic investments, it appears that the aim of imposing this tax was to regulate the investments made by individuals or groups of individuals in India who are otherwise not registered with the Securities and Exchange Board of India.

The exemption provided by the government to certain start-ups was a welcome step towards the promotion of investments in early stage start-up companies. As a result, eligible start-ups can raise investments above the fair market value, from resident angel investors, family or funds (which are not registered as venture capital funds), without any excessive tax implications.

While the intent of this change on taxing investments was to curb certain irregularities and tax avoidance practices, this has caused a substantial impediment for legitimate start-ups in raising much required funding that is key for the early stage ecosystem.