Understanding the Concept of Angel Tax & Its Impact on Startups

What is Angel Tax?

Angel Tax refers to a type of income tax that is levied on the capital raised by unlisted companies via the issue of shares where the share price is seen as exceeding the fair market value of the shares. The excess realization is treated as income and taxed accordingly. This tax was introduced to curb money laundering through high share premiums and has been a point of significant debate, especially in startup ecosystems.

The term was first coined in India, where it specifically impacts early-stage startups and the angel investors funding them. The tax applies to the funds that startups receive from domestic angel investors if the investment is made at a valuation higher than the market valuation considered 'fair' by the Income Tax Department. Angel Tax has been a concern for many startups, fearing that it could discourage angel investments, which are a crucial source of funding for them in their early stages.

Table of Contents

1. Background
2. What is Angel Tax?
3. Changes by Central Board of Direct Taxes (CBDT) Related to Angel Tax
4. Concerns of Amendments in Angel Tax on the Indian Start-Ups
5. Exceptions to Section 56(2)(viib): Angel Tax Exemptions
6. Conclusion

A start-up is a budding business endeavor seeking to establish itself in the market. Hence, it requires adequate capital and financial backing from third parties for leveraging. Banks usually don’t lend to start-ups, since they are considered as high-risk investments as per the risk defining criterion maintained by banks. So start-ups often turn to Angel Investors – the affluent individuals who are captivated by the novel idea and support start-ups by offering necessary capital in exchange for convertible debt or ownership equity.

Finance is one of the most pivotal ingredients for startups to thrive, but the burden of taxes often poses challenges for these businesses in attracting necessary funds. Here’s where angel tax comes into the picture – a levy imposed by the government on startups to broaden its tax revenue. Given that these investments are received by the startups from Angel Investors, taxation of the same is termed as Angel Taxation.

1. Background

The term Angel Tax was first introduced in the Finance Act, 2012 and became applicable in April 2013. This tax was implemented with a specific purpose in mind – to discourage the generation and utilization of unaccounted money through investments in closely held companies.

2. What is Angel Tax?

Angel Tax, in essence, is a financial term that refers to the tax obligations imposed on funds raised by unlisted companies. This occurs through the issuance of shares in off-market transactions, particularly when the funds secured from an investor surpass the fair market value of the company.

The excess realization of money is considered as “Income from Other Sources” and therefore, taxed accordingly under Section 56(2) (viib) of the Income Tax Act, 1961 (‘the Act’) and is chargeable at the tax rate applicable to the companies.

For instance, say if the fair market value of share price of Ola is Rs. 1100 per share and the company raises fund at Rs. 2250 per share which is significantly higher than its fair market value. In this case, the excess premium collected by the company (which is an unlisted company) over its fair market value i.e. Rs. 1150 per share will be treated as income from other sources as per Section 56(2)(viib). Consequently, tax shall be applicable on this surplus amount which is referred to as Angel Tax. 

3. Changes by Central Board of Direct Taxes (CBDT) Related to Angel Tax

One significant amendment incorporated in the latest Union Budget 2023 in the domain of direct taxes is the expansion of the scope of Section 56(2)(viib) of the Act, commonly referred to as ‘Angel Tax,’ to include non-residents i.e. now when a start-up raise funding from a foreign investor, the excess money i.e. premium on shares will be treated as income under the head “Income from Other sources”.

4. Concerns of Amendments in Angel Tax on the Indian Start-Ups

The amendment introduced by the CBDT vide Finance Act, 2023, extending scope of angel tax to include foreign investors, shall exert negative influence on Indian start-up ecosystem. This is primarily due to the fact that that foreign investors form the major funding alternatives for the Indian start-ups, and if the same are covered under the ambit of angel tax, it may potentially lead to many start-ups relocating their operations overseas.

5. Exceptions to Section 56(2)(viib): Angel Tax Exemptions

Notification No. 29/2023 outlines three categories exempt from angel tax provisions effective from May 24, 2023:

• Government and Government related investors,
• Banks or regulated entities involved in insurance business, and
• SEBI registered Category-I Foreign Portfolio Investors, Pension Funds, Endowment Funds, and Broad-Based Pooled Investment Vehicles or funds with more than 50 investors being resident in any country from a list of 21 jurisdictions.

Notification No. 30/2023 provides an exemption from angel tax for start-ups that meet criteria set by the Department for Promotion of Industries and Internal Trade when issuing shares at a premium, with a self-declaration requirement. This exemption applies retroactively from April 1, 2023.

For example, Peter Thiel is the co-founder of PayPal and also a well-known angel investor. As he is from United States, one of the countries among the list of 21 jurisdictions, if any premium is paid by him for investing in any unlisted company in India, the said premium shall be exempt from angel taxation as per Section 56(2)(viib) of the Act if Mr Peter falls under the Category-1 Foreign Portfolio Investors.

6. Conclusion

India is the second largest start-up hub in world in terms of number of business promotion. While government aims to achieve the goals of “Make in India”, the start-up sector is facing challenges since the introduction of Angel Tax.

However, despite the inclusion of non-residents under the ambit, the exemptions brought under Section 56(2)(viib) by the Finance Ministry this year aims to ease foreign institutional inflow into the startups thereby regulating startup ecosystem in India and providing some relief to budding start-ups.