There is no denying the fact that India has been the global leader in terms of creating successful entrepreneurship opportunities in the last few years. The investor community across the globe including high net worth individuals (HNIs), foreign funds, venture capitalists, angel investors and many others have remained bullish on the growth potential promised by the fast developing Indian startup ecosystem. However, while on one hand, government initiatives such as Startup India, Stand-up India Digital India give a favourable growth push to the Indian startup ecosystem, the term ‘Angel Tax’ has remained the nightmare for the entire Indian startup community. Recently, CBDT shook off the startup ecosystem by directly deducting income tax under section 68 from the bank accounts of certain startups on unexplained cash credits made into the accounts.
In the subsequent sections we will discuss what the term “angel tax” actually means and why its introduction has been causing such a furore in the Indian startup community.
What is Angel Tax?
Angel Tax is a term basically used to refer to the income tax payable on the capital raised by unlisted companies via the issue of shares through off-market transactions. But then, what is the problem in that? Shouldn’t every company pay its due share of taxes? True, the catch is in the manner in which the angel tax is imposed and computed.
Angel tax is levied on the capital raised via the issue of shares by unlisted companies from an Indian investor if the share price of issued shares is seen in excess of the fair market value of the company. The excess realization is considered as income and therefore, taxed accordingly.
Angel tax essentially derives its genesis from section 56(2)(viib) of the Income Tax Act, 1961. The finance act, 2012 introduced section 56(2)(viib) in the IT act which taxes any investment, received by any unlisted Indian company, valued above the fair market value by treating it as income. The investment in excess of fair value is characterised as ‘Income from other sources’ and the tax imposed on it is known as Angel Tax since it largely affects angel investors investing in startups.
Which investments fall under the ambit of Angel Tax?
Angel tax is imposed only on investments made by a resident investor. It should be noted that angel tax is not applicable in case the investments are made by any non-resident or venture capital funds.
Angel Tax Exemption
Allaying the concerns of the startup community, the government has exempted investments made by the domestic investors in companies approved by an inter-ministerial panel from Angel Tax.
However, in order to qualify for angel tax exemption, the startup should meet certain criteria which are as follows:
The paid-up capital and share premium of the startup should not exceed Rs. 10 crore after issuing shares.
The startup should procure the fair market value certified by a merchant banker.
The investor should have a minimum net worth of Rs. 2 crores and the average income in the last 3 financial years should not be less than Rs. 50 lakh.
The startup should have received approval from a 8 member interministerial board for angel tax exemption.
In order to simplify the compliance procedure, the government in a recent notification has done away with the requirements fair market value certificate issued by a merchant banker and approval from an interministerial board. The eligible startup can simply request angel tax exemption from the Department of Industrial Policy & Promotion (DIPP) with applicable supporting documents. The application of DIPP-recognised startups will be forwarded to CBDT (Central Board of Direct Taxes) along with the attached documents. CBDT has been mandated to accept or decline such an application within 45 days from the day of receipt.
What is the rate at which angel tax computed?
Angel Tax is levied at a hefty rate of 30.9% on net investments in excess of the fair market value. So for example, if a startup receives 50 crore of investment by issuing 1 lakh shares at Rs.5000 each to an Indian investor and the fair market value is Rs.2000 per share i.e Rs.20 crore only, then the startup will have to pay angel tax on the amount in excess of the fair market value i.e Rs. 30 crore. Therefore Angel Tax payable in this transaction will be Rs. 9.27 crore (30.9% on Rs.30 crore).
Why is the startup community opposing Angel Tax?
The imposition of angel tax hinges on the fair market valuation of the company and this has been a bone of contention between startups and the income tax department. The tax department goes by the rule book and calculates market value based on the net assets of the company. However, estimated growth prospects of the startup and future projections based on these growth prospects are major factors in determining the fair market valuation of the startup. The methodology difference in calculation of the market value of the startup makes it pay a hefty price in terms of angel tax at a whopping 30%. Angel tax in a way wipes away a major part of the investible surplus of the startup hurting its growth prospects and hitting hard on the viability of the business.
However, after facing a sustained backlash from the startup ecosystem against the imposition of angel tax, the government has finally assured the startups that no coercive action will be taken to collect angel tax and also appointed a committee to look into this issue