Background – Sec 56(2)(viib), Income Tax Act
Where a closely held company (generally private companies and unlisted public companies) issues its shares at a price which is more than its fair market value then the share premium received in excess of fair market value of shares will be charged to tax in the hands of the company as income from other sources. This was made keeping in view the practice of closely held companies (private companies bringing in undisclosed money of promoters/directors by issuing shares at high premium which is normally over and above the book value of share of the company, and moreover which escaped the provisions of section 68 (unexplained cash credits).
For the purposes of this clause,
(a) the fair market value of the shares shall be the value—
(i) as may be determined in accordance with such method as may be prescribed; or
(ii) as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature,
whichever is higher;
In short, Angel tax is triggered when a startup receives an equity infusion in excess of “fair valuation.” Income Tax authorities treat the premium paid by investors as income, taxable at 30%. Now the Government has put forth with a relaxation on this taxation. The angel tax strikes at the very core of an innovative start- up as there is no specific definitive method for determining the FMV of a start-up. External investors are investing in an idea which has the potential of scaling up and being successful. Start-up companies are thus finding it difficult to justify their fair market value to IT officers seeking to levy the angel tax. Consequently, the angel tax is levied and the start-ups become liable under law to pay a huge part of their funding as tax.
Companies which receive funding are sometimes just in their initial stages of existence such as just developing their product or market strategy and are in dire need of funds to expand. The levy of such angel tax tantamount to critically impairing the development of these companies.
While the U.K., Singapore, the U.S. and others have schemes and tax breaks to incentivise angel investors, India is taking a regressive step to dissuade angels from investing in these companies. Ironically, these measures of section 56(2)(viib) apply to domestic investors and not to non-resident investors.
Since December 2018, a number of startups and organizations, including NASSCOM, the Indian Private Equity and Venture Capital Association (IVCA), the Indian Angel Network, iSPIRT Foundation, and LocalCircles, have written multiple letters to DIPP and CBDT demanding the abolition of angel tax. The penalty for tax-evasion, along with the levy itself, can exceed over 100% of the funds raised, the foundation alleged. As a result, seed-investment in startups was down by 21% in 2018. The Department of Industrial Policy and Promotion (DIPP) has notified an amendment to the angel tax rule that will bring some relief to Indian startups, even though the government has stopped short of abolishing the contentious norm.
Terms and conditions attached
- As per the amendment, startups incorporated before 2016 that have received up to Rs 10 crore in angel funding will not have to pay angel tax. This will be applicable only to companies with a revenue of less than Rs 25 crore.
- The Indian government said startups seeking an exemption from angel-tax notices will not require certification from an inter-ministerial body anymore. Instead, new applications will have to be filed through the department of industrial policy and promotion (DIPP), which will be evaluated by the central board of direct taxes (CBDT) in 45 days.
- Each time a company raises funds and requests an exemption, it is required to submit a slew of documents. Despite the recent changes, these applications will still be scrutinized by tax authorities.
- The angel-tax rules still require investors to upload income-tax returns, total assets, and net-worth certificates. Angel investors have been particularly wary of this provision.
- An angel investor picking up stake in a startup will need to have a minimum net worth of Rs 2 crore and should have an average annual income of Rs 25 lakh while filing tax returns in the preceding three years.
- In addition, there are concerns about the red tape that might be involved in getting funding. Every fresh infusion would require approval from the inter-ministerial board which in turn could delay the process. A merchant banker will also need to certify the valuation.
The government had earlier tried to give a concession to startups by stating that only those companies that fulfil the conditions specified by the DIPP as per a circular dated 17 February 2016 are eligible for the angel tax exemption. Since 2016, startups have been registering themselves with the DIPP and do not face Central Board of Direct Taxes (CBDT) scrutiny over angel investments. Most startups have successfully registered with the government agency.