Angel Tax – A Dispiriting and Ambiguous Tax on Startups

Last Updated at: November 04, 2019
2083
Angel Tax – A Dispiriting & Ambiguous Tax on Startups

The Indian Tax system has undergone multiple changes in the last couple of decades. The government is concerned that these investors may try to park their illegal income on these businesses and thus have implemented an ambiguous tax on angel investments. To promote a healthy startup environment, the government has taxed such investments.

The Indian Income Tax in the recent years has undergone several amendments, most of which are directed to plug escapes in income. With digitization and foreign investments strengthening our startup network, there are many more funding routes available now than what was accessible to startups in India years ago. With this boom, several creative ways came to be devised to clandestinely convert black money into a regular investment, under the garb of lending to startups.

Below you’ll find the list of services that will walk you through the need for the service, the eligibility, documentation procedure and benefits. Our experienced team members are there to guide you and complete the process at ease.

 

What is Angel Investment?
In simple terms, Angel investment is one of the earliest rounds of funding for a startup. After the bootstrapping stage, that usually covers for initial registration, license fees and operating charges, the Angel investor takes a leap of faith by lending money to the startup, with no guarantee of the returns on investment. This is usually the trickiest stage, as the business struggles to prosper and become profitable and usually once this happens, the startup can seek better investment through Venture Capital Funding.

Get Your Company Registered

So, why’s it being taxed?
Since the Angel investor is usually assuming a higher risk than any other investor, the government is concerned about those investments where shares of the startup are being bought at a higher value than the fair value. For example, if the fair value of the shares of a startup is ₹100 per share, and the Angel investor agrees of pay ₹150 per share, it may be possible that the Angel investor is looking to park his illegal or untaxed income in the startup at a higher value to legitimize it and also reap returns from this investment. Since the government wants to promote a healthy startup culture, the idea behind introducing this tax is to discourage startups from becoming a tool of money laundering and income conversion.

Who is responsible for paying Angel Tax and at what rate?
Unlike capital gains, that arise to the person transferring the shares (called transferor), the burden of paying the Angel tax is, unfortunately on the startup. So, for every share that is sold at a price in excess of its fair market value, the start-up needs to pay a tax of 30.9 per cent on the excess. Continuing from our example, if the startup has received shares worth ₹150 for a fair value of ₹100, 15 rupees would be taxable at 30.9%.

It has come to be realized that there exist several disadvantages and ambiguities in the angel tax regime.

Befuddling Fair Market Valuations: For a mature business, fair market valuation is easier, as it depends on the valuations in the previous rounds of funding and there exist performance track records to refer to. For booming enterprises like a startup, fair market valuations are tricky because of the uncertainty of “current and future value creation”. The Income Tax department has been valuing shares of startups based on their net assets. Moreover, when the first round of Angel investment values the shares at ₹100 while another round values at ₹80, does it mean that the fair value becomes ₹80 and hence, the government can retrospectively tax the funding round at ₹100? Entrepreneurs at any stage would want a higher valuation, especially so when there little agreement on what quantifiable “fair value” is for the startup, the ambiguity associated with taxing early startups makes survival difficult.

While entrepreneurs desperately hoped for Angel Tax abolition in the last budget session, several startups, especially unregistered ones have received notices. Startups meeting the DIPP Exemption criterion (of having less than 10 crore share capital etc) have also received notices for justifying non-payment of the Angel tax.

Taxing in the hands of a startup

While it is understandable that the government wants to discourage misuse of startup funding, it imposes the tax in the hands of the startup, in the form of Income from Other Sources. If the purpose is to eliminate illegal funding, why not trace the transaction back to the investor assessee, and tax the surplus investment in his hand? This reduces not just the compliance workload and notices received by startups but also gives them the encouragement that the amount received at higher valuations would not be subject to unfair taxation, and be available for use, in full.

At a time when we are progressively moving towards greater opportunities for businesses in India, through Make in India, establishing a Fund of Funds for startups, the change in the law relating to Angel Tax may help India in improving its startup ecosystem and boosting the funding flow, while also promoting healthy practices among investors.

With foreign investments and digitalization, startup companies are facilitated with other kinds of financial support too. Angel investors invest large amounts of money on startup companies. When these investors buy shares of a company at a higher value, the risk of their investment is much more because they may be trying to skip the tax of an amount that exceeds the lower tax limit.

Angel Tax – A Dispiriting and Ambiguous Tax on Startups

2083

The Indian Tax system has undergone multiple changes in the last couple of decades. The government is concerned that these investors may try to park their illegal income on these businesses and thus have implemented an ambiguous tax on angel investments. To promote a healthy startup environment, the government has taxed such investments.

The Indian Income Tax in the recent years has undergone several amendments, most of which are directed to plug escapes in income. With digitization and foreign investments strengthening our startup network, there are many more funding routes available now than what was accessible to startups in India years ago. With this boom, several creative ways came to be devised to clandestinely convert black money into a regular investment, under the garb of lending to startups.

Below you’ll find the list of services that will walk you through the need for the service, the eligibility, documentation procedure and benefits. Our experienced team members are there to guide you and complete the process at ease.

 

What is Angel Investment?
In simple terms, Angel investment is one of the earliest rounds of funding for a startup. After the bootstrapping stage, that usually covers for initial registration, license fees and operating charges, the Angel investor takes a leap of faith by lending money to the startup, with no guarantee of the returns on investment. This is usually the trickiest stage, as the business struggles to prosper and become profitable and usually once this happens, the startup can seek better investment through Venture Capital Funding.

Get Your Company Registered

So, why’s it being taxed?
Since the Angel investor is usually assuming a higher risk than any other investor, the government is concerned about those investments where shares of the startup are being bought at a higher value than the fair value. For example, if the fair value of the shares of a startup is ₹100 per share, and the Angel investor agrees of pay ₹150 per share, it may be possible that the Angel investor is looking to park his illegal or untaxed income in the startup at a higher value to legitimize it and also reap returns from this investment. Since the government wants to promote a healthy startup culture, the idea behind introducing this tax is to discourage startups from becoming a tool of money laundering and income conversion.

Who is responsible for paying Angel Tax and at what rate?
Unlike capital gains, that arise to the person transferring the shares (called transferor), the burden of paying the Angel tax is, unfortunately on the startup. So, for every share that is sold at a price in excess of its fair market value, the start-up needs to pay a tax of 30.9 per cent on the excess. Continuing from our example, if the startup has received shares worth ₹150 for a fair value of ₹100, 15 rupees would be taxable at 30.9%.

It has come to be realized that there exist several disadvantages and ambiguities in the angel tax regime.

Befuddling Fair Market Valuations: For a mature business, fair market valuation is easier, as it depends on the valuations in the previous rounds of funding and there exist performance track records to refer to. For booming enterprises like a startup, fair market valuations are tricky because of the uncertainty of “current and future value creation”. The Income Tax department has been valuing shares of startups based on their net assets. Moreover, when the first round of Angel investment values the shares at ₹100 while another round values at ₹80, does it mean that the fair value becomes ₹80 and hence, the government can retrospectively tax the funding round at ₹100? Entrepreneurs at any stage would want a higher valuation, especially so when there little agreement on what quantifiable “fair value” is for the startup, the ambiguity associated with taxing early startups makes survival difficult.

While entrepreneurs desperately hoped for Angel Tax abolition in the last budget session, several startups, especially unregistered ones have received notices. Startups meeting the DIPP Exemption criterion (of having less than 10 crore share capital etc) have also received notices for justifying non-payment of the Angel tax.

Taxing in the hands of a startup

While it is understandable that the government wants to discourage misuse of startup funding, it imposes the tax in the hands of the startup, in the form of Income from Other Sources. If the purpose is to eliminate illegal funding, why not trace the transaction back to the investor assessee, and tax the surplus investment in his hand? This reduces not just the compliance workload and notices received by startups but also gives them the encouragement that the amount received at higher valuations would not be subject to unfair taxation, and be available for use, in full.

At a time when we are progressively moving towards greater opportunities for businesses in India, through Make in India, establishing a Fund of Funds for startups, the change in the law relating to Angel Tax may help India in improving its startup ecosystem and boosting the funding flow, while also promoting healthy practices among investors.

With foreign investments and digitalization, startup companies are facilitated with other kinds of financial support too. Angel investors invest large amounts of money on startup companies. When these investors buy shares of a company at a higher value, the risk of their investment is much more because they may be trying to skip the tax of an amount that exceeds the lower tax limit.

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Avani Mishra is a graduate in law from the National Law Institute University, Bhopal. She qualified the Company Secretary course with an All India Rank 1 and is a recipient of the President’s Gold Medal for her academic distinctions. She also holds a B.Com degree with a specialization in Corporate Affairs and Administration.