India is often considered to be among the top start-up hubs in the world. However, the end of 2022 and the start of 2023 saw a steep decline in the funding received by these start-ups on the backdrop of the top US banks falling one after the other and the looming recession across the globe. Finance is one of the most crucial ingredients for the success of start-ups but taxes often deter these businesses from attracting sufficient funds. Here’s where angel tax comes in, This is the tax levied by the government on start-ups to increase their tax base. However, in 2019, the government has also provided relaxation on this tax as well to boost the funding of these start-ups. So if you are a start-up or wish to invest in one, read on to know all about the angel tax and the exemptions available under the Income Tax Act in this regard.
What is the meaning of Angel Tax?
The start-ups, especially in the early stages, meet their funding requirements in exchange for their equity as they have limited tangible assets to offer in return for the funds. This is where angel investors come into the picture as they have the potential to make higher returns from their investment in these start-ups. making them an attractive investment opportunity.
However, the Income Tax Act, 1961 has the concept of angel tax under section 56(2)(viib) which mandates that the start-ups (i.e., unlisted companies whose shares are not available for buying on the stock market) that receive funding from an angel investor must contribute a certain amount to the government.
This provision is triggered when the total investment value exceeds the company’s FMV or Fair Market Value and any investment above the FMV is considered “income from other sources,” and the tax levied on it is referred to as angel tax. This income is then taxed at the flat rate of 30% according to Section 56(2)(vii)(b) of the Income Tax Act which is considered to be quite steep and among the highest tax rates in the country. Additionally, the cess of 3% is also applicable to the tax making the effective rate of angel tax becomes 30.9%.
This tax was primarily introduced to address the concerns related to money laundering. In India, only a small percentage of the population actually complies with tax regulations. Many new businesses fail to maintain proper accounting records or accurately report their assets, resulting in the creation of black money. To mitigate this issue, the Income Tax department decided to tax private companies on the excess share premiums received above the fair market value.
What is the angel tax exemption and what are the latest changes to the same?
As discussed above the angel tax is levied on the investments received by the start-ups that are in excess of their fair market value. This tax incidence was creating a hindrance for the startups to attract sufficient funds and thereby meet their targeted growth. Therefore, in order to provide relief and to promote the ease of doing business in the country, the government has introduced a 100% exemption to the angle tax subject to fulfillment of certain conditions.
These conditions are highlighted hereunder.
- The startup must be recognized by the Department for Promotion of Industry and Internal Trade (DPIIT).
- The total paid-up capital of the startup should be less than or equal to 25 crores. However, this calculation does not include investments from non-resident investors, venture capital funds, and venture capital companies.
- The start-up should not have a turnover of more than Rs.100 crores
- The startup must be valued by a certified merchant valuer who determines its fair market value.
- The startup should not invest in certain assets within 7 years of issuing shares. These prohibited investments include buildings or land, loans, capital contributions to other entities, modes of transport costing more than 10 lakhs, jewelry, archaeological collections, and shares and securities.
However, there is an amendment in these conditions for claiming exemption from angel tax in the Finance Bill 2023. This amendment expanded the scope of angel tax to include non-resident investors as well. As a result, if an unlisted company receives a premium for issuing shares to non-residents that exceeds the fair value, that excess premium will also be subject to taxation in the hands of the company.
What are the consequences or penalties for not meeting conditions for exemption from angel tax?
The exemption from angel tax was introduced to ease the burden of the start-ups. However, its applicability is subject to the conditions mentioned above. In case the start-ups fail to comply with these conditions, they are liable for consequences which can be increased tax liability as well as penalty under the Income Tax provisions as the case may be. The details of these consequences are explained hereunder.
- If an eligible startup fails to meet the conditions specified in the Notification for exemption, such exemption from Angel Tax that was previously granted to the startup will be revoked.
- Subsequently, any consideration received by the startup before the failure, which exceeds the fair market value of shares, will be treated as income for the financial year in which the exemption is revoked.
- The revocation of the exemption implies that the startup is deemed to have under-reported its income. As a result, the defaulting startup will be subject to the consequences outlined under Section 270A of the Income Tax Act, which includes a penalty equal to 200% of the tax payable on the under-reported income.
The Indian government is taking many efforts to create a favourable environment for start-ups in the country and attract investments to meet their funding requirements. The angel tax exemption is a step in this direction and aims to provide much-needed relief to these early-stage start-ups to boost their earnings potential and their ultimate growth.
Angel investors are individuals or groups who provide early-stage funding to startups in exchange for ownership equity or convertible debt. They offer not only financial support but also mentorship and industry expertise to help startups grow and are crucial for fostering innovation and economic growth in the startup ecosystem.
Angel tax is levied as per the provisions of section 56(2)(vii)(b) and is taxed at the rate of 30% excluding cess and surcharge.
Start-ups meeting all the eligibility criteria as per the provisions of the Income Tax Act, 1961 are eligible to get a 100% exemption from paying angel tax under section 56(2)(vii)(b).
One of the major drawbacks of angel tax is the substantial tax burden it places on startups, which are already struggling to raise funds.