Will Angel Tax Get Angel Wings? Startups Pin Hopes on Union Budget

Indian startups are eagerly anticipating the Union Budget 2024, set to be presented in Parliament today, with hopes that the government will address their long-standing concerns about the Angel Tax. This tax has been a contentious issue, stifling the growth and funding of many startups. The startup community is advocating for its rationalization or complete removal, aiming to boost investment and foster a more conducive environment for innovation and entrepreneurship in India.

Understanding Angel Tax: What Is It?

Angel Tax, governed by Section 56(2)(viib) of the Income-tax Act, 1961, was introduced to tax investments in closely held companies that exceed the fair market value (FMV) of the companies. This excess amount is treated as income and taxed under the head ‘Income from other sources’ in the hands of the company issuing the shares. The term ‘Angel Tax’ emerged as it primarily affects investments made by angel investors in early-stage startups. It was first introduced in the Union Budget 2012 by then Finance Minister Pranab Mukherjee under the UPA-II regime.

The Rationale Behind Angel Tax

The government introduced Angel Tax as an anti-abuse measure to curb the misuse of closely held companies for laundering unaccounted money. Unlike publicly traded companies, closely held companies face fewer regulations. The tax aimed to increase transparency and accountability, ensuring that investments reflect genuine business interests rather than serving as vehicles for black money.

Amendments Over the Years

Initially, the Angel Tax provisions applied only to investments made by resident investors. However, the Finance Act 2023 expanded the scope to include non-resident investors as well. This change meant that any consideration received for the issuance of shares, regardless of the investor's residency status, was subject to Angel Tax. The government also introduced some relaxations for specific categories of investors to mitigate the tax’s impact.

Concerns of the Industry

Despite its intent to curb black money, Angel Tax has inadvertently penalized genuine investments in startups. For early-stage companies, access to funds is critical. However, the Angel Tax can claim up to 30% of the investment, posing a significant hurdle to fundraising and growth. This tax contradicts the government's mission to improve the ease of doing business in India and has been a major concern for the startup ecosystem.

Government Measures and Relaxations

From its inception, investments by venture capital funds or companies in venture capital undertakings were exempt from Angel Tax. The government also provided exemptions for certain startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) with share capital below Rs 25 crore. Further relaxations in 2023 included exemptions for government and related investors, banks, insurance entities, and specific investors from 21 notified jurisdictions. The government also revised valuation methodologies to ensure fairer FMV calculations, introducing a safe harbour rule for price variations up to 10% from the FMV due to factors like forex fluctuations and economic indicators.

Expectations from Budget 2024

While the government’s initiatives have provided some relief, the startup community is optimistic that Budget 2024 will bring more comprehensive measures. The DPIIT secretary has recommended the removal of Angel Tax provisions, which would significantly enhance capital formation in the country. At a minimum, the industry seeks rationalization of the tax, including exemptions for tax-neutral transactions such as amalgamations, de-mergers, rights issues, and conversions of convertible instruments.

The Union Budget 2024 is seen as a critical juncture for addressing these concerns, and the startup ecosystem is hopeful for a more supportive and investment-friendly regulatory environment.

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