What is Angel Tax? Is it bad for startups in early stages?

India has developed a thriving startup culture over the past two decades. The government has emphasised on the importance of startups for economic growth and initiated several policies for their rise. This includes the Startup India Initiative and changes in self-certification and compliance regarding certain environmental and labour laws. But, the angel tax remains a matter of concern for the startup world. The tax was implemented in 2012 and it has resulted in several issues for the country’s startup ecosystem.

In May this year, the Central Board of Direct Taxes proposed an amendment in the Finance Act, 2023, to bring in changes in the angel tax and ease entrepreneurs’ woes.

Here’s a detailed look at what the angel tax is and how it impacts India’s startup culture.

What is an angel tax?

An angel tax is imposed on unlisted businesses that get funding from an angel investor. When an angel investor funds the new business ventures, the startup is obliged to pay a part of their investment as tax to the government under Section 56 (2) (vii) (b) of the  Income Tax Act of 1961. The crux of the matter surrounds whether the investment amount surpasses the company's Fair Market Value (FMV). The angel tax is imposed at 30.9 per cent if the amount invested exceeds the startup’s FMV.

Why was the angel tax introduced?

The government introduced the angel tax to curb money laundering and make it easier for businesses to comply with the tax norms.

Is angel tax bad for startups in early stages?

Startups have certain issues with the angel tax surrounding a number of factors from funding to getting finance for restructuring of expansion plans.

Hinders expansion: Since startups frequently lack tangible assets many businesses go to angel investors who see their potential and offer financial support in return for equity. But, if the investment exceeds the FMV, it is regarded as ‘income from other sources,’ which attracts angel tax. This can make it tough for new companies to implement their expansion plans.

Pushes startups to uncertainty: High Net-Worth Individuals (HNIs) and angel investors can be unwilling to invest in startups due to the angel tax. This can result in a paucity of funds for many entrepreneurs.

Determination of financial value is tough: It is not easy to define the exact fair market value of a startup, particularly in its early stage. It may result in disputes with tax authorities, prolonged assessments and unnecessary burdens. It can also lead to Indian startups being unable to generate enough funding to compete at the global level.

What amendments in angel tax did CBDT talk about?

According to an official release, the CBDT proposed modifications in Rule 11UA which prescribes two methods for valuation of shares. The amendment proposed five more valuation methods for non-resident investors and asked for price matching for resident and non-resident investors with regards to investment by Specified Funds or Venture Capital Funds.