Angel tax exemption: Is there a real benefit?

By Nivedita Nivargi and Bhadra Menon, Samvad Partners

The government introduced the Startup India Action Plan on 16 January 2016, in an effort to boost the startup ecosystem and promote ease of doing business. As a part of the action plan, various steps are being taken to foster seed investment in early-stage businesses.

Nivedita Nivargi, Samvad Partners
Nivedita Nivargi
Samvad Partners

Startups rely heavily on funding. Typically, investment in a startup is made by issuing shares at a premium, which is calculated based on the valuation of the company. As most startups are at a conceptualization stage, valuation usually takes into consideration forward-looking projections, which renders the process subjective. Therefore, arriving at an appropriate valuation and determining the fair market value (FMV) of the shares is more of an art than a science.

However, issuance of shares to a resident of India for a premium in excess of the FMV is taxed exorbitantly. This tax, known as “angel tax”, is levied under the head “income from other sources”, under section 56(2)(viib) of the Income Tax Act, 1961 (ITA). However, the tax is not imposed if the investment is from a venture capital company or a venture capital fund. Angel tax has been a long-standing pain-point for early-stage businesses.

The concept of taxing excess premium was introduced in the Finance Act, 2012, to deter the generation and use of unaccounted money. Although startups raise genuine investments on the basis of their “idea”, there have been multiple occurrences of them receiving notices from the tax department invoking section 56(2)(viib) of the ITA. Further, startups usually submit a valuation report prepared by a chartered accountant based on a discounted cash flow method. In some instances, the assessing officers have either rejected or modified valuation reports, stating that the valuations were abnormal, resulting in an increase in the taxable amount.

With this in mind, the Department of Industrial Policy and Promotion (DIPP) issued a notification on 11 April 2018, allowing eligible startups an exemption from angel tax. The Central Board of Direct Taxes also issued a notification on 24 May to the same effect.

Bhadra MenonAssociateSamvad Partners
Bhadra Menon
Samvad Partners

The DIPP notification maintains status quo in the definition of startup and the process of recognizing an entity as a startup, but prescribes stringent conditions to apply for the exemption.

The angel tax exemption is available only if the startup is a private limited company recognized by the DIPP and the following conditions are met: (i) the aggregate amount of paid-up share capital and share premium after the proposed issue cannot exceed ₹100 million (US$1.4 million); (ii) the investor has an average returned income of ₹2.5 million and a net worth of ₹250 million or more for the three preceding financial years; (iii) the startup should obtain a report from a merchant banker registered with the Securities and Exchange Board of India specifying the FMV; and (iv) an application is submitted in Form-2 (annexed to the DIPP notification) to the Inter-Ministerial Board of Certification, which has the power to approve, reject or revoke the application.

Complying with these conditions could be a tall order, mainly because of the two-step verification process, firstly by the DIPP for recognition as a startup and secondly by the inter-ministerial board to determine whether the startup is entitled to the exemption. The notification implies that this procedure will have to be completed prior to the issuance of shares to the investor. Apart from the procedural difficulty, this time-consuming process will delay closing of the fund-raising exercise.

The compliance requirements are also onerous for investors, who will need to furnish copies of their income tax returns for the latest three financial years and a copy of the latest financial year’s balance sheet. Most investors will be hesitant to provide these documents as they are confidential.

Perhaps the most stringent requirement is that the valuation certificate must be obtained from a merchant banker instead of a chartered accountant. Previously, a valuation certificate from a chartered accountant was sufficient for valuation under the Companies Act, 2013, the Foreign Exchange Management Act, 1999, and the ITA. But, as a result of the DIPP notification, startups will have to get a valuation report from a merchant banker, both for the purposes of the exemption and under the ITA. This will substantially increase the costs to often struggling startups.

Although the DIPP notification seeks to relieve startups from crippling taxes, many startups will not be able to enjoy this intended benefit due to their inability to comply with the conditions. Perhaps for this reason, the government intends to evaluate the effects of the notification prior to 31 March 2019, which hopefully will result in changes that are more meaningful for the startup community.

Nivedita Nivargi is a partner and Bhadra Menon is an associate in the Bengaluru office of Samvad Partners.

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