Angel tax: An overview

In the last few years, angel tax has caused considerable concerns within the startup community in India. Changes initiated to address such concerns in the angel tax framework has created uncertainty within the startup ecosystem. A timeline of the devleopments related to angel tax is available here. This article deconstructs the existing framework governing angel tax and highlights the underlying issues.

What is angel tax?

1. Introduced through the Finance Act, 2012, angel tax is imposed on investments raised by an unlisted company from an Indian resident by issue of shares of the company in excess of fair market value^[1] of the shares.^[2] The difference between the fair market value of the shares and the investment is taxed as ‘income from other sources’ under Section 56(2) (viib) of the Income Tax Act, 1961 (“IT Act”) or what came to be known as the angel tax.

2. Presently, the angel tax is not applicable on investment up to INR ten (10) crores. The IT Act provides that angel tax would not apply where the consideration for issue of shares is received by:^[3]

• By a venture capital undertaking^[4] from a venture capital company or a venture capital fund, or
• By a company from a class or classes of persons as may be notified by the Central Government in this behalf.

3. In June 2016, the Central Board of Direct Taxes (“CBDT”) issued a notification which granted exemption from angel tax on investments in startups that are registered in accordance with the notification by Department of Industrial Policy and Promotion (“DIPP”).

4. According to the aforementioned DIPP notification, it categorised an entity as a startup if–

• Its turnover for any financial year does not exceed more than INR twenty-five (25) crores,
• Up to five (5) years since the date of incorporation or registration of the entity, and
• The entity shall be working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property.

Recent Developments

5. In April 2018, under the Startup India Action Plan, the DIPP changed the definition of a startup through a new notification (“Notification”). The entities now need to satisfy the following conditions to be categorised as a startup:

• Entity incorporated as, either a Private Limited Company or a Limited Liability Partnership up to seven (7) years from its date of incorporation/ registration.
• Biotechnology startups up to ten (10) years from its date of incorporation/ registration.
• Turnover for any financial year shall not exceed INR twenty-five (25) crores since the date of incorporation.
• Any entity shall not be formed by splitting up or reconstruction of a business already in existence.
• Entity shall be working towards innovation, development or improvement of products or process or services, or if it is scalable business model with a high potential of employment generation or wealth creation.

6. In addition, startups must satisfy the following conditions to apply for exemption from angel tax:

• The total amount of paid-up share capital and share premium of the startup after the proposed issue of shares should not exceed INR ten (10) crores.
• Obtain a report from merchant banker specifying the fair market value of shares in accordance with Rule 11UA of the Income Tax Rules 1962.

Who is an eligible investor?

7. According to the Notification, an investor or proposed investor must satisfy the following conditions to be eligible for exemption from angel tax:

• An average returned income of INR twenty-five (25) lakhs or more for the preceding three financial years.
• A net worth of INR two (2) crores or more as on the last date of the preceding financial year.

How to be recognised as a startup eligible for angel tax exemption?

8. The procedure to avail exemption from angel tax has been laid down in the Notification by DIPP which is as follows:

• File for an online application over the mobile app or portal of DIPP.
• The application needs to contain: (i) A copy of Certificate of Incorporation or Registration; and (ii) A write-up about the nature of business highlighting how it is working towards innovation, development or improvement of products or process or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.

Existing concerns around angel tax

9. The startup community continues to have issues with the Notification.

10. Earlier, startups had a choice to obtain a fair market valuation document from either the merchant banker or the Chartered Accountants. The Notification has removed the option to obtain a fair market valuation through a Chartered Accountant. Instead, they need to obtain a report from a merchant banker specifying the fair market value of shares as per the Rule 11UA(1) (c) of the Income Tax Rules, 1962.

11. Therefore, obtaining a fair value certificate from a merchant banker will act as a compliance burden for startups.

[This post has been co-authored by Karan Dhingra, a fifth-year student of Jindal Global Law School, during his internship with TRA and Pushan Dwivedi, Associate, TRA.]

^[1] Section-11UA of the Income Tax Act, 1961; [(1)] For the purposes of section 56 of the Act, the fair market value of a property, other than immovable property, shall be determined in the following manner, namely,—

(c)valuation of shares and securities,—

(c) the fair market value of unquoted shares and securities other than equity shares in a company which are not listed in any recognized stock exchange shall be estimated to be price it would fetch if sold in the open market on the valuation date and the assessee may obtain a report from a merchant banker or an accountant in respect of which such valuation.

^[2] Section-56(2) (viib) of the Income Tax Act, 1961; Where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:

Provided that this clause shall not apply where the consideration for issue of shares is received—

(i)  by a venture capital undertaking from a venture capital company or a venture capital fund; or

(ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf.

^[3] Section-56(2) (viib) of the Income Tax Act, 1961

^[4] Section-10 (23FB) (c) of the Income Tax Act, 1961; Any income of a venture capital company or venture capital fund from investment in a venture capital undertaking :

Provided that nothing contained in this clause shall apply in respect of any income of a venture capital company or venture capital fund, being an investment fund specified in clause (a) of the Explanation 1 to section 115UB, of the previous year relevant to the assessment year beginning on or after the 1st day of April, 2016.

Explanation.—For the purposes of this clause,—

“venture capital undertaking” means—

1. a venture capital undertaking as defined in clause (n) of regulation 2 of the Venture Capital Funds Regulations; or
2. venture capital undertaking as defined in clause (aa) of sub-regulation (1) of regulation 2 of the Alternative Investment Funds Regulations;