Implications of Angel Tax for Startups and Investment

Source-This post on Implications of Angel Tax for Startups and Investment has been created based on the article “Drop the angel tax: Stop taxing startup investments as income” published in “Live Mint” on 10 July 2024.

UPSC Syllabus-GS Paper-3- Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment.

Context– The article discusses the issues associated with imposition of angel tax in India. The Department for Promotion of Industry and Internal Trade (DPIIT) is reportedly considering relief for startups from this tax.

What is India’s ‘angel tax’?

Angel tax in India, governed by Section 56(2)(viib) of the Income Tax Act since 2012, applies to startups that receive investments from angel investors above the fair market value of their shares. Any excess valuation is taxed as income for the startup.

What are the problems with the imposition of this tax?

1) Flawed Assumptions- A high share premium usually results from valid business decisions. For instance, if a company initially issued few shares at a low value but now has a much higher valuation, it can legally issue shares at a higher price per share under Indian law. However, such scenarios face scrutiny under angel tax regulations.

2) Scrutiny Selection Process- The tax department employs Computer-Aided Selection of Cases for Scrutiny (CASS). An examination of companies receiving notices indicates that one criterion for angel tax is whether a startup, despite facing early-stage losses, issued shares at a premium. These initial losses are common for startups and do not imply a lack of value creation.

3) Issues with Implementation – It is problematic when assessing officers compare startup projections with actual performance without considering deviations in valuation reports. New businesses operate under more uncertainty and the equity risk taken by investors covers it.

What is the impact of imposition of this tax?

1) Startup Funding – Startup funding dipped by an estimated 63% in 2023 compared to the previous year.2023 saw the lowest amount of startup funding raised in six years.

2) Non-Resident Investors- Section 56(2)(viib) was extended to non-resident investors with certain exceptions. However, given that about 85% of Indian startup capital originates from abroad, this extension has been particularly detrimental.

3) Impact on Investment– It turns capital into taxable income, which goes against the goal of attracting more investment to the country.

What measures were taken by the government?

The Department for Promotion of Industry and Internal Trade (DPIIT) introduced relief measures in February 2019 exempting startups from the angel tax for shares issued up to ₹25 crore, provided certain conditions were met.

Read More- Centre softens angel tax rules

What are the issues with these measures?

3 restrictions severely impacted this exemption:

A) Prohibition on giving loans and advances

B) Restriction on capital contributions to other entities

C) Limitations on investments in shares and securities

2) The restrictions last for seven years after the fund-raise. Since a firm can remain a DPIIT startup for 10 years, these rules can affect routine transactions for up to 17 years. Many startups chose not to take the 2019 exemption because of these strict conditions.

What should be the way forward?

1) Exclude unlisted companies from Section 56(2)(viib), mirroring the exclusion for listed companies. This will protect genuine startups from harassment while still allowing tools to catch fraudulent entities.

2) Removing Section 56(2)(viib) could reverse the decline in startup funding and boost confidence among entrepreneurs and investors. It wouldn’t compromise India’s efforts against unaccounted funds and could greatly benefit the Startup India initiative.

Question for practice

What are the issues associated with Angel tax’s implementation? What are the consequences of imposing this tax?