Angel tax is essentially the tax that unlisted companies (read-startups) are liable to pay on the capital they raise through issue of shares. Except that there is a catch.
What is Angel Tax?
There may be some companies that are doing extremely well operationally, and investors wait with bated breath to buy the shares of such companies when first shares are issued. In such a situation, the company, knowing its brand value and market expectations, may issue shares at a price way higher or over what a comparable stock may be granted at in the market. In a scenario like that, unlisted companies have to pay income tax on the money raised through such an issue. The excess of funds raised at prices above fair value is treated as income, on which tax is levied.
What is angel tax today, came into being after a financial amendment was introduced in 2012 in the form of Section 56 (2) (viib) of the Income Tax Act to plug money laundering practices. Here any unlisted company (usually startup enterprises) in receipt of investment which is above the fair value will have to treat the extraneous capital as ‘income from other sources’ which would be identified and taxed. Given that the tax implication majorly rested with angel investors, meaning ones who put their money behind startups, it came to be called an angel tax.
To whom does the tax apply?
It applies to resident Indian investors only.
Problems With The Angel Tax
Ever since its introduction, the tax came under criticism by investors, industry analysts and entrepreneurs for being cumbersome and startup unfriendly. They said that calculating a startup’s fair market value had subjective aspects to it which could not be standardised since a startup’s valuation may be based on something as simple as projected returns at a given point and is subject to negotiations between the startup and investor. Another problem was, assessing officer, a key tax official who scrutinises the books, would choose cash discounted flow to determine the fair market value, which was not a very favourable practice for startups. In December 2018, more than 2000 startups received tax notices to pay up dues on the angel tax, including penalty charges.
Are There Exemptions On Angel Tax?
Much to the relief of investors and startup founders, Indian Finance Ministry in its Union Budget of 2019 diluted the tax rules by stating that if startups and investors filed the required declarations and returns, they would not be subjected to income tax scrutiny.
In an announcement by the Finance Ministry in 2019, startups registered under Department for Promotion of Industry and Internal Trade (DPIIT) are exempt from angel tax. All that a startup needs to do is apply for eligibility to DPIIT along with necessary documents and returns which will then be sent to CBDT (Central Board of Direct Taxes) for final approval. The CBDT reserves the right to decline the exemption status for a company.
Now, according to the revised rules, the companies need to meet certain requirements to be eligible for the exemption-
1. Paid-up capital, along with the premium on shares, cannot exceed Rs.10 crore post-issuance of shares.
2. Earlier administration required a merchant banker must certify the startup’s fair market value. But this rule has been made away with since 2019.
3. The lower limit for investor’s net worth has been fixed at Rs. 2 crore and average income cannot be less than Rs. 50 lakh in the last three consecutive financial years.
What Is The Applicable Angel Tax Rate?
Investments over and above the fair market value are taxed at 30.9%. Let us see an example-
Startup ABC garners Rs. 30 crore from issuing 75000 shares to domestic investors at Rs.4000 per share. The fair market value was calculated to be Rs. 1000 per share. So the fair market valuation of shares stands at Rs. 7.5 crore. Then, ABC will have to pay up 30.9% angel tax on the excess amount above the fair market value (Rs. 30 crore- Rs7.5 crore), which is 30.9% on Rs.22.5 crore. ABC will effectively pay Rs.6.9 crore in the form of tax.
Tax rules on angel tax stand considerably watered down in terms of compliance. If a startup, is registered under DPIIT, it is also exempt from this tax.