[Answered] Explain the concept of angel tax. How does it impact investments in start-ups?

Angel Tax is a 30% tax that is levied on the funding received by startups from an Angel investor. However, this tax is levied when startups receive angel funding at a valuation higher than its ‘fair market value’. It is counted as income to the company and is taxed. Section 56(2) VII B of the Income Tax Act colloquially known as the angel tax was first introduced in 2012. The aim was to discourage the laundering of unaccounted money via unlisted firms disguised as capital investments.

Here’s how angel tax can impact investments in startups:

• Reduce cash flow: Angel Tax creates cash flow constraints as startups depend on funds to fuel their growth and operations. The tax reduces the capital raised, hindering their expansion plans.
• Increased Compliance Burden: Determining the fair market value of a startup, especially in its early stage, is challenging due to limited financial data, leading to disputes with tax authorities, resulting in prolonged assessments and unnecessary burdens. This often involves providing extensive documentation and evidence to tax authorities, which can be time-consuming and costly.
• Delayed Funding: Angel tax generates uncertainty and apprehension among angel investors and HNIs, discouraging them from investing in startups, and thus affecting the availability of funds for budding entrepreneurs. These delays can affect a startup’s ability to secure timely capital and execute its business plans.
• Reduced Attractiveness:  Indian startups face a competitive disadvantage compared to their global counterparts as foreign startups do not have a similar tax burden, affecting India’s startup ecosystem. Investors may be hesitant to invest in startups if they believe that the valuation could trigger angel tax, leading to taxation on their investments.
• Tax Liability for Startups: The high tax liabilities divert the focus of startup founders from innovation and business growth to tax compliance, paperwork, and legal complexities, potentially stifling innovation and hindering the overall development of the startup ecosystem.

Conclusion:

Angel tax has remained a source of controversy within the Indian startup landscape, affecting not only the growth prospects of startups but also investor sentiment and overall confidence in the ecosystem. Nevertheless, India has an opportunity to foster its entrepreneurial community and position itself as a global centre for innovation and startup excellence by finding a harmonious equilibrium between taxation and support.