The imposition of Angel Tax on startups has been a topic of much debate recently. Previously, only investments made by Indian residents were subject to the tax, but the Finance Bill of 2023 has expanded its scope to include non-resident investors. This tax grants excessive power to officials and is contradictory to the objective of promoting a thriving startup ecosystem.

Concerns about the negative impact of funding for startups have been raised by stakeholders, including venture capitalists. The current amendment to the Finance Bill 2023 has eliminated the exemption for overseas investors, requiring them to pay tax on deals. As a result, if startups receive funding from non-resident investors, it will be considered taxable income.

Let's first understand what Angel Tax is and why startups have to pay it. 

What is Angel Tax?

Angel Tax refers to a tax levied on investments made by angel investors in startups or small and medium enterprises to prevent money laundering through the issue of shares at a premium valuation. However, it ended up discouraging angel investors and startups as heavy taxation and regulatory scrutiny were applied. Changes have since been made to ease the burden on startups and angel investors.

TICE News spoke with Mr Vinod Bansal, Co-founder & CFO, Inflection Point Ventures, to clarify the Angel Tax. 

Mr Bansal explains that Angel Tax refers to the tax levied on capital raised by unlisted companies through the issue of shares where the share price exceeds the fair market value of the shares issued. The excess is treated as income of the startup and taxed at the applicable rate. Angel Tax is not applicable to debt funds, but it covers non-residents as per the budget 2023.

Mr Anil Joshi, Managing Partner at Unicorn India Ventures say defines Angel Tax as, “The Angel Tax is levied on the companies (startup) on the net investments in excess of the fair market value under section 56 (2)(viib) and the same was introduced into act in 2012.”

The Jurisdiction of Angel Tax

Angel Tax is not applicable to debt funds. The levy of angel tax is followed not only in India but in many other countries. Earlier, angel tax was applicable only to the domestic investors but as per the budget 2023, it now covers the Non-Residents too, explains Mr Bansal.

What is fair market valuation?

Have you ever wondered how a company's fair market value is determined? Let's consider the case of a tech startup that doesn't have many assets. The founder claims that the company is worth Rs 100 crore, but many investors may find this amount to be overvalued and may not want to invest. However, if the founder can find an investor who shares their vision and is convinced of the valuation, they may invest in the company. At face value, this seems like a legitimate transaction between two consenting parties.

On the other hand, tax authorities typically use only two methods to value a company: the book value or the discounted cash flow method. If a company's valuation exceeds the amount determined by a tax officer who is not involved in the business, the assumption is that there is some sort of wrongdoing involved. The administration holds the view that there cannot be multiple viewpoints on valuations. If the company's revenues in the following years do not match the projections made at the time of valuation, the suspicion grows even stronger.

While it is possible that some startups or investors are deliberately evading taxes, it is unfair to judge everyone based on this assumption. Some valuations may simply be a result of genuine errors. The fact remains that valuations are subjective, and what may seem overvalued to one person may not be to another.

TICE News asked the Venture Capitalist as to why the startups have to pay Angel Tax.

When asked by TICE News about the reasoning behind why Angel Tax  startups, Venture Capitalist Mr. Bansal explained that it serves as a measure to prevent money laundering. By discouraging individuals from using investments in startups to convert their unaccounted wealth into legitimate assets, the tax aims to promote transparency and accountability.

However, the tax has been criticized by many startups and angel investors who argue that it hinders innovation and makes it more challenging for startups to attract funding. To address these concerns, some countries have introduced exemptions and incentives to encourage angel investment and support startup growth.

Mr. Bansal supports the Angel Tax levy but suggests that it should only be applied to cumulative net profits, calculated by setting off operational losses against deemed income from shares issued at a price above their fair market value over a 3-5 year period. 

“This would alleviate the burden of this tax from the startups that are incurring loss over a number of years and will help raise funding by the startups. This will create a more stable and robust startup ecosystem, which can ultimately benefit the broader economy,” Mr Bansal adds.

Mr Anil Joshi says, “The startups which raises money at value excess of the fair market value are subject to Angel tax as it is considered as income in the hands on the startups under section 56 (2)(viiib).”

He further adds that ,"Most of the founders start the company just with an idea and angel money comes in very handy to support their idea to make it an reality. In 50% of the cases Angel investors lose money as the startup failure rate is very high as the idea may be ahead of its time or startups fail to raise further money and runs out of the money before the product or service become commercial success. Hence levying angel tax on startups further deplete their cash in hand, meaning if the startup has raised Rs 1 cr and is subject to angel tax then they will pay almost 30.9% tax on the amount which is in excess of fair market value. Hence money raised will reduce by approx. 31% on account of angel tax.”

The Angel tax was introduced to plug the tax leakage, however there is need to safe guard genuine startups from angel tax else the startups will be discouraged to raise the angel money as it becomes very expensive in absence of proper mechanism. Considering, India growing very fast in the startup space and is now 3rd nation in the world as startup nation, we need better mechanism and the process to safe guard genuine startups from the angel tax and make process simpler enabling them to focus on building product and services for success. If they are successful, not only they will create lot of jobs but will pay much more tax then meagre initial tax on angel raise, Mr Joshi opines.   

The Impact of Angel Tax on Startups and Angel Investors

Angel Tax is a tax levied on investments made by angel investors in startups or small and medium enterprises to prevent money laundering through the issue of shares at a premium valuation. 

However, it ended up discouraging angel investors and startups as heavy taxation and regulatory scrutiny were applied. The levy of angel tax is followed not only in India but in many other countries. While the tax serves as a measure to prevent money laundering, it has been criticized by many startups and angel investors who argue that it hinders innovation and makes it more challenging for startups to attract funding. 

The Finance Bill of 2023 has expanded the scope of the tax to include non-resident investors, which has raised further concerns. To address these concerns, some countries have introduced exemptions and incentives to encourage angel investment and support startup growth. It remains to be seen whether the Indian government will consider such measures to alleviate the burden of Angel Tax from startups and support the growth of the startup ecosystem.