An Analysis of Angel Tax

Introduction

The provisions relating to angel tax in the Income Tax Act, 1961 ( “IT Act” ) were primarily introduced to regulate funding received by unlisted companies from angel investors and specifically, to curb money laundering and funneling of black money into the start-up ecosystem.

Originally, under section 56(2)(viib) of the IT Act ( “angel tax provision” ), an unlisted company[1] receiving any consideration for issue of shares exceeding the face value of such shares from any person being a resident, the aggregate consideration received for such shares as exceeding the fair market value ( determined in accordance with Rule 11UA of Income Tax Rules, 1962 ) ( “FMV” ) was liable to tax in the hands of such company as ‘income from other sources’. This provision, commonly referred to as ‘angel tax’, was inserted by the Finance Act, 2012 to prevent the circulation of unaccounted money as share premium. Since non-resident investors were always subject to pricing and other regulations under Indian exchange control laws ( “FEMA” ), investments by non-residents were initially kept out of the angel tax provisions.

While this provision was benign for a long time, the growing entrepreneurial spirit of young professionals in India coupled with rampant fund raising by start-ups led to an increased scrutiny by the Assessing Officers under the IT Act ( “AOs” ) on income tax filings of these companies, including invocation of the angel tax provisions to question the ( sometimes inflated ) valuation of such companies.

What is Angel Tax?

Angel tax is the tax paid by unlisted companies on gaining funding from angel investors through issuing shares. The companies doing very well operationally use their brand value to get funding and issue shares at a price more than its fair market value. The company’s excess earnings are considered income from other sources.

Who are Angel Investors?

An Angel Investor generally refers to a wealthy person who makes investments in up and coming startups to obtain equity ownership. They are different from venture capital firms because they invest their own money.

Therefore, the tax levied on their investment is called an Angel Tax. Such tax is not levied on foreign investors or venture capital funds/companies. Angel Investors are also called seed investors, angel funders, business angels, or just informal private investors.

What is the Applicability of Angel Tax?

Now you must think that the entire funding the company receives is taxable. However, this is not true. Tax is levied only on the premium amount received by the company. In simple words, the difference between the face value of the shares issued and the actual value of the shares is calculated and taxed at the applicable rate.

Let’s take a general example –

Suppose A Ltd. and B Ltd. manufacture pens and sell them at ₹20 and ₹8, respectively. The cost of manufacturing a pen is ₹10. Now, A Ltd. is a renowned brand, and people are willing to purchase its product even after paying ₹20.

The extra ₹10 that people are willing to pay for the pen of A Ltd. is the premium amount or the extra amount earned by the company.

Now let us understand this with a financial example –

Every company’s shares have a fair value and a market value. Suppose Chiggy Ltd., a food delivery company, receives angel funding of 1 crore. Out of this, 70 lakhs is the face value of the shares, and 30 lakhs are the premium amount that the investors are willing to pay for the shares of Chiggy Ltd. Now, angel tax is applied and calculated on this 30 lakhs, i.e., the premium amount instead of the total amount of funding received.

What are Angel Tax Exemptions?

Earlier, the consideration received in the form of angel investment was chargeable to tax under section 56(2)(viib) under the ‘Income From Other Sources’ head. However, the Indian government brought about exemptions in Angel Tax for startups in 2019 to encourage ease of doing business. Startups are now exempt from paying angel tax subject to the following conditions –

• (1) The Department for Promotion of Industry and Internal Trade ( DPIIT ) should recognize the startup.
• (2) The total paid-up capital of the startup should be less than or equal to 25 crores. However, the calculation of the paid-up capital shall not include the consideration received in respect of shares issued to a non-resident, a venture capital fund and a venture capital company.
• (3) A certified merchant values must value the startup and find its fair market value.
• (4) The startup must receive angel investment from foreign investors and not resident investors.
• (5) The startup should not invest in any of the following within 7 years of issuing the shares –

• (1) Building or land
  • (2) Advancing loans
  • (3) Capital contribution to any other entity
  • (4) Any mode of transport costing more than 10 lakhs
  • (5) Jewellery
  •  
  •  (6) Archaeological collections and Shares and securities.

What are the Rates of Angel Tax in India?

The angel tax is levied at the rate of 30% in India, and an additional cess of 3% is also applicable to it as per section 56(2)(vii)(b) of the Income Tax Act, 1961. The effective rate of the angel tax is 30.9%.

Recent Amendments to Valuation of Companies for Angel Tax

Realizing the pitfalls of extending the angel tax provisions to non-resident investors, the Central Board for Direct Taxes ( CBDT ) issued a notification dated September 26, 2023 providing additional flexibilities in the FMV valuation rules for angel tax provisions ( “Amended Valuation Rules” ), such as:

1. New Valuation Methods

The Amended Valuation Rules increase the number of prescribed valuation methods for the purpose of angel tax from the existing 2 methods ( net asset value and discounted cash flow method ) to 7 ( including comparable company multiple method, probability weighted expected return method, option pricing method, milestone analysis method and replacement cost methods ). This could provide investors and start-ups with more flexibility and hence, encourage the start-up ecosystem in India. However, the valuation needs to be time-bound, as the report from the merchant banker cannot be obtained more than 90 days before the date of the issue of shares.

2. VC Funds/ AIFs

Another major characteristic of the Amended Valuation Rules is price matching for resident and non-resident investors with reference to investments by VCs or specified funds, including Category I and II AIFs registered with the SEBI. To illustrate, if a venture capital undertaking receives a consideration of Rs. 50,000 from a venture capital company[8] for issue of 100 shares at the rate of Rs. 500 per share, then such an undertaking can issue 100 shares at this rate to any other investor ( including a non-resident investor ) within a period of 90 days before or after the receipt of consideration from venture capital company.

One would hope that some non-resident investors which are active in the Indian FDI space may set up fund structures in India to avail the above concession and be exempt from the rigors of the angel tax provisions. However, this may also require the investee entity to have strong bargaining power to convince a non-resident investor to register as a category I or II AIF, since the tax liability will be on the investee entity only, and not on the investor.

3. Safe Harbor Variation

 Further, the Amended Valuation Rules provide for a “safe harbor” clause, which allows for a 10% variation between the valuation price and issue price, to account for forex fluctuations, bidding processes and variations in other economic indicators, which may affect the valuation of the unquoted equity shares during multiple rounds of investment. This is a welcome insertion as it gives more breathing room to start-ups as well as investors by acknowledging the volatility of the fundraising process.

Impact on Ease of Doing Business

The Government’s focus on FDI and campaign on ease of doing business in India is common knowledge. In light of the issues and hurdles discussed above, risk averse foreign investors may continue to prefer externalized structures requiring Indian entrepreneurs to flip entities to reside and receive investments outside India, thereby undermining the entire play for ease of doing business in India.

While adding more valuation methods, keeping a certain class of non-resident investors outside the ambit of angel tax and price-matching features are positive steps to provide flexibility to companies in the fund-raising process, they do not solve the larger issue concerning angel tax. Arguably, all this tinkering has taken angel tax away from its originally stated purpose of regulating the flow of unaccounted money as share premium and has given rise to innovative lawyering and complex tax structuring of equity fund raising in India.

Impact of Angel Tax

The Parliament amended Section 56 of the IT Act through Clause 32 of the Finance Bill 2023 Section 56(2) (viib) aims to regulate share premium of a company by taxing the capital generated by the company through the sale of shares at a price higher than the market price ( fair market value ). To better understand this section, we need to examine its objective. This tax is usually referred to ‘angel tax’.

The Problem:

For example, consider a company ABC Private Limited. It has shares of face value Rs 10/-. ABC Private Limited is engaged in development of innovative services. ABC Private Limited was burning cash heavily since the majority of the expenditure is pumped into research & development. ABC Private Limited is approached by investors who want to invest seeing the future of the product which is being developed by ABC Private Limited. Accordingly, after several rounds of negotiation, the value of share is fixed at Rs 350/- per share and investors pumped in funds at such value.

ABC Private Limited has issued 1, 00,000 shares at Rs 350/- per share to the Investor. Immediately, the tax authorities propose a demand under Section 56(2)(viib) stating that ABC Private Limited has received consideration for issuance of shares which is more than FMV of shares say Rs 50/- as per BV method. Accordingly, a tax demand was made to the extent of Rs 3 Crores ( 1, 00,000 shares * ( 350-50 ) per share ).

Now ABC Private Limited has to approach the tax authorities and justify the value of shares as Rs 350/- and not Rs 50/- as proposed by authorities. This will take a good enough time and ABC Private Limited instead of spending time in innovation spends time at Tribunals and Courts to deal with this matter.

This is the acute problem faced by every ‘start-up’ in India which received consideration from the investor. Investor would not leave a single stone unturned to see that he is not paying more than what the share is worth. The general ideology of the investor is to invest into the company when it is in its young stage and exit when it is in its growth stage. Hence, he would not invest more than what the company is worth. The tax authorities, keeping aside all these, propose to tax such excess consideration in the hands of the company who is receiving the monies for issuance of shares.

Definition of Start-Up:

An entity shall be considered as a ‘start-up’:

• Up to 10 years from date of incorporation/registration
• Turnover of entity for financial years since incorporation has not exceeded INR 100 Crores
• Entity is working towards innovation, development or improvement of product or processes or services, or if it is scalable business model with a high potential of employment generation or wealth creation

An entity ceases to be ‘start-up’ once it completes 10 years or turnover exceeds INR 100 Crores. Eligible ‘start-up’ should make an application and submit relevant documents to get recognized under this Notification.

Relief from Section 56(2)(viib):

A start-up shall be eligible for exclusion from the provisions of Section 56(2) (viib) by issue of notification by CBDT, only if it fulfills the following conditions:

• Such start-up is recognized under this Notification or earlier notifications issued by Ministry
• Aggregate amount of paid up share capital and share premium of the start-up after issue or proposed issue of share, if any, does not exceed Rs 25 Croresand
• It has not invested in specified assets

Let us proceed to understand in detail the above conditions to evaluate the relief from Section 56(2)(viib).

 Importance of New Rules

• These rules will certainly ease the burden for startups, which are in dire need of capital to fund their growth and other business needs.
• The changes will motivate wealthy individuals to invest in startups that receive capital at a premium due to their innovative business model, even though the valuation is not justified by the physical assets they hold.
• Furthermore, since the new rules are applicable retrospectively, many young companies which received notices from the Income Tax Department in the past will be relieved by this change in the rules.

Consider the following statements

• Angel investors are high net worth individuals who invest their personal income in business start-ups or small and medium scale companies.
• Angel Tax, formally known as Section 56 (2) (viib) of the Income Tax Act, was introduced in 2010.
• Exemption from angel tax was for companies with turnover up to Rs 500 crores as per old rules.
• Exemption from angel tax for companies has been increased to 200 crores as per new rules.

Conclusion

This article will describe in detail the topic of Angel Tax in India. There were a few changes made to the tax laws related to Angel Tax. This article starts by sharing brief details on Angel Investors, their rising importance, and then moves on to the formulation of new rules related to Angel Tax, the significance of those new rules and finally culminating with the concerns associated with changes in the Angel Tax Laws.

Support our journalism by subscribing to Taxscan premium. Follow us on Telegram for quick updates