The key issue with the angel tax has always been that it was challenging for startups to justify their valuation. See how the abolition of Angel Tax help the startups.
The abolition of the Angel Tax in the 2024 budget for all the classes of investors represents a significant reform that will benefit India’s startup ecosystem as a landmark decision. This decision will boost confidence among investors, particularly at a time when startup funding in India has declined by 3.8% to $5.1 billion in the first half of 2024 compared to the same period in 2023.
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Angel Tax, as covered under the Section 56(2)(viib) of the Income Tax Act, 1961, was introduced in 2012 with the objective of addressing concerns related to money laundering and the flow of unaccounted funds. It refers to the tax payable by unlisted companies on capital raised if the value of the shares issued to investors exceeds their fair market value (FMV). This difference is taxed at the rate of 30.9%.
The key issue with the angel tax has always been that it was challenging for startups to justify their valuation, which is typically based on future projections of the start-up and as per negotiations with the investors. As per the industry stakeholders, the taxation authorities failed to distinguish between genuine and fraudulent cases with the tax authorities beginning to issue notices to start-ups questioning their valuation methodology. During its tenure, the angel tax regime was a persistent challenge for startups, which struggled to defend their valuation due to lower revenues, leading to tax implication which often wipes away a major part of the investible surplus of startups raising funds, thereby hurting their growth prospects.
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Over the last few years, several exemptions were introduced to address this issue. For example, start-ups registered with the Department of Promoter of Industry and Internal Trade (“DPIIT”) were exempted from this requirement until the aggregate amount of paid-up share capital and share premium does not exceed Rs 25 corers (excluding any investment received from a non-resident or venture capital fund).
Furthermore, efforts were also undertaken to provide relief through amendments to Rule 11UA of the Income Tax Rules, 1962 – such as introducing various valuation methods and allowing a safe harbor of up to 10% variance in share value. Till 2023, the investment by non-resident investors were also outside the ambit of the angel tax, but this exemption was withdrawn by the Finance Act, 2023. Post that CBDT issued notification to provide welcome relief to the DPIIT registered start-ups for non-residents as well. Despite efforts to provide relief through amendments to Rule 11UA of the Income Tax Rules, 1962 and CBDT notifications – such as introducing various valuation methods and allowing a safe harbor of up to 10% variance in share value – alongside exemptions for DPIIT registered startups and specific investor categories, the fundamental issue still persisted.
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Despite the above, concerns have been lingering in the ecosystem on several issues, including where start-ups raised funds collectively from both angel investors and non-resident investors or how to address requests from investors to obtain valuation reports at a discount to FMV in order to be able to exercise their anti- dilution price protection rights in case of down rounds in the future. While angel tax was applicable on all unlisted companies, the early-stage companies faced significant challenges.
The abolishment of the angel tax will indeed bring clarity to the startup ecosystem in India.
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The elimination of the angel tax is poised to alleviate these challenges significantly by reducing compliance burdens and financial strains for startups. It is a strategic step towards inducing domestic capital formation, and enhancing the ease of doing business, and ultimately contributing to job creation and technological advancement in the country. Removing barriers like angel tax can make a country more attractive for entrepreneurs and investors, fostering a more vibrant startup ecosystem. This initiative showcases the government’s commitment to fostering a vibrant startup ecosystem.
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