Understanding the Concept of Angel Tax & Its Impact on Startups

Table of Contents

1. Background – Angel Tax
2. What is Angel Tax?
3. Changes by Central Board of Direct Taxes (CBDT) Related to Angel Tax
4. Concerns of Amendments in Angel Tax on the Indian Start-Ups
5. Exceptions to Section 56(2)(viib): Angel Tax Exemptions
6. Conclusion

A start-up is a budding business endeavor seeking to establish itself in the market. Hence, it requires adequate capital and financial backing from third parties for leveraging. Banks usually don’t lend to start-ups, since they are considered as high-risk investments as per the risk defining criterion maintained by banks. So start-ups often turn to Angel Investors – the affluent individuals who are captivated by the novel idea and support start-ups by offering necessary capital in exchange for convertible debt or ownership equity.

Finance is one of the most pivotal ingredients for startups to thrive, but the burden of taxes often poses challenges for these businesses in attracting necessary funds. Here’s where angel tax comes into the picture – a levy imposed by the government on startups to broaden its tax revenue. Given that these investments are received by the startups from Angel Investors, taxation of the same is termed as Angel Taxation.

1. Background – Angel Tax

The term Angel Tax was first introduced in the Finance Act, 2012 and became applicable in April 2013. This tax was implemented with a specific purpose in mind – to discourage the generation and utilization of unaccounted money through investments in closely held companies.

2. What is Angel Tax?

Angel Tax, in essence, is a financial term that refers to the tax obligations imposed on funds raised by unlisted companies. This occurs through the issuance of shares in off-market transactions, particularly when the funds secured from an investor surpass the fair market value of the company.

The excess realization of money is considered as “Income from Other Sources” and therefore, taxed accordingly under Section 56(2) (viib) of the Income Tax Act, 1961 (‘the Act’) and is chargeable at the tax rate applicable to the companies.

For instance, say if the fair market value of share price of Ola is Rs. 1100 per share and the company raises fund at Rs. 2250 per share which is significantly higher than its fair market value. In this case, the excess premium collected by the company (which is an unlisted company) over its fair market value i.e. Rs. 1150 per share will be treated as income from other sources as per Section 56(2)(viib). Consequently, tax shall be applicable on this surplus amount which is referred to as Angel Tax. 

3. Changes by Central Board of Direct Taxes (CBDT) Related to Angel Tax

One significant amendment incorporated in the latest Union Budget 2023 in the domain of direct taxes is the expansion of the scope of Section 56(2)(viib) of the Act, commonly referred to as ‘Angel Tax,’ to include non-residents i.e. now when a start-up raise funding from a foreign investor, the excess money i.e. premium on shares will be treated as income and chargeable under this Section.

4. Concerns of Amendments in Angel Tax on the Indian Start-Ups

The amendment introduced by the CBDT vide Finance Act, 2023, proposing to extend scope of angel tax to include foreign investors, shall exert negative influence on Indian start-up ecosystem. This is primarily due to the fact that that foreign investors form the major funding alternatives for the Indian start-ups, and if the same are covered under the ambit of angel tax, it may potentially lead to many start-ups relocating their operations overseas.

5. Exceptions to Section 56(2)(viib): Angel Tax Exemptions

A startup shall qualify for an exemption to Section 56(2)(viib) of the Act or the provisions of the aforesaid section shall not be applicable to the following:

• Start-ups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT).
• Aggregate amount of paid-up share capital and share premium of the start-up does not exceed Rs. 25 crores. (Total share capital shall not include shares issued to venture capitalists)
• Investors from 21 countries including the US, UK and France to which exemption is granted in May, 2023 by Finance Ministry. However, it did not include investment from Singapore, Netherlands and Mauritius – which have traditionally been key geographies for start-ups to raise money.

For example, Peter Thiel is the co-founder of PayPal and also a well-known angel investor. As he is from United States, if any premium is paid by him for investing in Zomato, the said premium shall be exempt from angel taxation as per Section 56(2)(viib) of the Act.

6. Conclusion

India is the second largest start-up hub in world in terms of number of business promotion. While government aims to achieve the goals of “Make in India”, the start-up sector is facing challenges since the introduction of Angel Tax.

However, despite the inclusion of non-residents under the ambit, the exemptions brought under Section 56(2)(viib) by the Finance Ministry this year aims to ease foreign institutional inflow into the startups thereby regulating startup ecosystem in India and providing some relief to budding start-ups.