Cracking the Angel Tax Code: Insights, Savings, and Justification

Angel Tax on startups has often been a topic of discussion. It is so important that it was even included in the election manifestos of political parties. Today, let's understand what Angel Tax means, why it is levied on startups, and delve deeper into the intricacies of Angel Tax and its implications.

What is Angel Tax? 

The tax imposed on capital raised by unlisted companies through share issuance at a price exceeding the fair market value is called Angel Tax. This excess is considered income for the startup and taxed accordingly. Initially applicable only to domestic investors, the 2023 budget extended its jurisdiction to cover non-residents as well.

Angel Tax was introduced 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. But now, over the period of time several changes have been made to ease the burden on startups and angel investors.

TICE News spoke to industry experts to know all about the Angel Tax.

Vinod Bansal, Co-founder & CFO, Inflection Point Ventures, explains, "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 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.”

Understanding Fair Market Valuation

Determining a company's fair market value is crucial in assessing Angel Tax implications. Tax authorities typically rely on methods like book value or discounted cash flow. However, this approach may not always align with the perceived value by investors and entrepreneurs.

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.

Rationale Behind Angel Tax

Startups are known for their innovative and disruptive ideas that have the potential to change the world. However, setting up a business from scratch requires a considerable amount of investment, and this is where angel investors come into the picture. Angel investors, also known as private investors, invest their own money in startups in exchange for an ownership stake.

Explaining the reasoning behind why Angel Tax  startups, Venture Capitalist Mr. Bansal explains 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.   

Is Angel Tax A Hurdle For Startups?

While angel investors are essential for startups, the concept of Angel Tax can create hurdles for entrepreneurs. Angel Tax is a tax levied on the excess capital that a startup raises through the issue of shares to its investors. The tax can be as high as 30%, and it applies to any amount raised above the fair market value of the shares.

The primary purpose of Angel Tax is to prevent money laundering, but it has turned into a massive headache for startups. The tax has been criticized for being unfair, and it has hindered the growth of many startups. This is why it is essential for startups to save on Angel Tax.

One way to save on Angel Tax is by ensuring that the startup's valuation is reasonable. Startups often overvalue their business to attract angel investors, but this can backfire when it comes to paying Angel Tax. It is essential to get the valuation right and to avoid raising capital at a premium that is higher than the fair market value.

How To Save On Angel Tax? Experts Talk

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 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).

Not all startups are subject to Angel Tax, the startups which are not registered under DIIP as startups and doesn’t have the enterprise valuation certificate from the certified valuer are subject to Angel Tax. The startups which are registered under DIIP as startups and have valuation certificate from certified valuer are exempted from angel tax, he pointed.

Mr Vinod Bansal says “Depending on the country or region, some startups may be eligible for tax exemptions or benefits. In India, if a company is a DPIIT recognised startup and has obtained angel tax exemption, subject to fulfilment of eligibility criteria for availing exemptions u/s 56(2)(vii)(b) of the Income Tax Act, it shall be exempted from Angel tax.”

He advises the startups to set a realistic share price. To avoid a high Angel Tax, startups should set a realistic share price which is in line with the valuation of the company. The Investments made by Category I AIFs, which are registered with SEBI, are exempted from Angel Tax. 

Another way to save on Angel Tax is to ensure that the startup is registered as a private limited company. The government has provided exemptions for Angel Tax for startups registered as private limited companies, provided that they meet certain criteria.

“Startups can consider seeking investment from accredited investors who meet the criteria to save the tax. Consider other sources of funding: Startups can also consider other sources of funding such as crowdfunding for Non-Profit Organizations and specific grants approved by the government that do not attract Angel Tax,” he suggests.

Why Is It Important to Save Angel Tax?

Startups, dependent on angel investors for funding, face hurdles due to Angel Tax, which is levied on excess capital raised through share issuance. To avoid this, startups should ensure their valuations are reasonable and the company is registered as a private limited company to meet criteria for exemptions. 

It's also essential to pay Angel Tax to demonstrate compliance with the law, maintain reputation, and avoid legal and financial troubles. Advice from Venture Capitalists includes setting realistic share prices, seeking investments from accredited investors, and considering other sources of funding like crowdfunding or government-approved grants.

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