India’s ‘angel tax’ has been a topic of significant debate, often described as an innocuous term with severe implications. Recently, it has resurfaced in the news as Budget 2024-25 has relieved startups from this tax liability. This tax, unique to India, converts capital into taxable income, which seems counterintuitive in a country aiming to attract capital. Here’s a closer look at the angel tax, its evolution, and the arguments for its removal.
Introduction of the Angel Tax
The angel tax was introduced in 2012 by then Finance Minister Pranab Mukherjee as part of a series of measures titled “Measures to prevent generation and circulation of unaccounted money.”
This tax, codified in Section 56(2)(viib) of the Income Tax Act, targets unlisted companies that issue securities at a premium. If the price at which these securities are issued is higher than their “fair market value,” the difference is taxed as income in the hands of the issuing company.
Evolution and Impact on Startups
In 2016, the scope of this section was extended to include startups raising capital from angel investors—primarily high net-worth individuals and family offices. Dubbed the ‘angel tax,’ it was initially applicable only to investments from Indian residents but was extended to non-residents (with certain exemptions) from the financial year 2023-24 onwards.
The tax’s flawed assumption that a high share premium is indicative of unaccounted funds has had dire consequences for startups. A high share premium can result from legitimate business decisions, such as low initial issuance of shares or significant growth in business valuation. However, this has often led to tax notices, disrupting the operations of nascent businesses.
Consequences and Criticisms
One major criticism is the method used by the tax department to scrutinize cases. The computer-Aided Selection of Cases for Scrutiny (CASS) system employs data analytics and taxpayer profiling to identify cases non-discretionarily. Notices are frequently issued to loss-making startups issuing shares at a premium, ignoring the fact that early-stage losses are normal as startups invest heavily in teams, product development, and marketing. The tax was leading to unfair assessments and penalize genuine businesses.
Additional Administrative burden in the process of defending the valuations before tax authorities is an expensive process for young companies. Angel tax has resulted in many Indian entrepreneurs shifting or setting up their business in more supportive environments.
Attempts at providing exemption from the tax
In 2019, DPIIT attempted to provide relief by exempting DPIIT-recognized startups from the angel tax for up to ₹25 crore worth of shares issued at a premium, provided certain conditions were met. However, restrictions on loans, advances, and certain investments crippled this concession, leading many startups to surrender the exemption.
The extension of the tax to non-residents in 2023-24 included additional valuation methods, a 10% leeway on issue price variance, and a list of safe-harbour countries. Yet, these measures have not mitigated the adverse impact. The Indian startup ecosystem, which sources around 85% of its capital from abroad, saw a significant dip in funding, estimated at 63% year-on-year in 2023, reaching its lowest in six years.
Abolishment of the tax finally!
Budget 2024-25 finally abolished this tax and bought an extra cheer to the Startup Industry which is struggling currently due to valuation and corporate governance issues. Angel tax removal would align India with global practices, encourage investment, and foster an environment where startups can flourish, ultimately benefiting the Indian economy.
Akansha Rathi and Associates (ARACS), Company Secretary Firm in Navi Mumbai is engaged into compliance related services. We have a team of experts who not only possess required skills and experience but also have worked in complex business environment and were engaged in providing complex solutions in terms of providing related Compliance services to our clients.