‘Angel Tax’ in India

Recent Developments on ‘Angel-Tax’ in India 

1. Brief background 

The term ’Angel-Tax’ does not technically exist under the Indian Income-tax Act, 1961 (‘IT Act’).  It is the fallout of an extreme interpretation and regressive application of an already existing provision in the IT Act to moneys raised by ‘Startups’ in India by way of equity share capital.  In line with the ‘Startup India’ initiative in 2016, the Startup Notification (defining and governing eligible Startups and their regulatory framework) was issued by Government of India in 2016 and at the same time, the IT Act was also amended to introduce a beneficial provision facilitating a 100% tax break for such eligible Startups for any three (3) consecutive years out of seven (7) years commencing from year of its incorporation.  The Startup Notification has undergone several revisions1 till date and the latest Startup Notification stands as of February 19, 2019.  

While the Startup Notification is the genesis of Startups in India and contains the overall framework, terms, definitions and conditions for an eligible Startup, the IT Act also lays down its own terms and conditions for claiming tax break.  Eligible Startups have to be engaged in eligible business2.  Per Startup Notification, an entity may qualify as an eligible Startup for 10 years from its incorporation while tax break under IT Act would be available for only 3 consecutive years (out of seven years from its incorporation).  Similarly, per Startup Notification, the maximum limit for total turnover of an entity to qualify as eligible Startup is INR 1 bn (c. USD 15 mn) during the aforesaid 10 year period while under IT Act (for tax break purposes) the maximum limit for eligible Startup is INR 250 mn (c. USD 3.6 mn).  Accordingly, a Startup with eligible business and registration having turnover between INR 250 mn (c. USD 3.6 mn) to INR 1 bn (c. USD 15 mn) would qualify as an eligible Startup for purposes of Startup Notification but not for the purposes of claiming tax break under IT Act. 

1. What is not an eligible Startup? 

For income tax purposes an entity formed by splitting up or reconstruction of an existing business or an entity whose total turnover exceeds INR 250 mn (c. USD 3.6 mn), shall not be considered an eligible Startup. 

As per Startup Notification, an entity whose total turnover exceeds INR 1 bn (c. USD 15 mn) at any time during 10 consecutive years from its incorporation shall not be considered an eligible Startup.   

1. Extreme interpretation of existing provision in IT Act resulting in ‘Angel-Tax’ 

Section 56(2)(viib) of IT Act was introduced in 2012 to arrest laundering of funds. It provides that if a private company issues shares to a resident (Indian person/entity) and receives consideration thereof exceeding the ‘fair market value’3 of such shares issued, then such excess shall be taxed in hands of the private company as ‘Other income’ at the maximum marginal rate applicable, typically 30% (excluding surcharge and cess).  However, venture capital firms and other categories specified/to be specified by Government were exempt from the rigours of this provision, i.e., they could raise money without being worried too much over valuation/issue price.   

1. The key issue 

Typically, a Startup private company would factor desired valuation based on various criteria – such as goodwill or other intangibles, unique business model, etc. through DCF method and submit the same in order to satisfy the requirement of Section 56(2)(viib) and avoid its severity.  However, between 2016 to 2018, tax authorities started rejecting and modifying such valuation reports by treating them as based on abnormal valuations and this resulted in huge additions being made to taxable income of these Startup private companies leading to huge tax demands in their tax assessments.  For Startups, this effectively morphed as a tax on their capital and the potential impact on their cash flows was overwhelming.  This led to a huge protest across the Startup industry culminating into various representations to the Government.     

The issue has been briefly explained in this illustration.   

1. Damage control by the Government 

To assuage the matters, in February 2019 Government of India provided a specific exemption to qualifying Startups from the rigours of valuation of Section 56(2)(viib) of IT Act.  Qualifying Startups are defined to mean Startups which are private companies (a) issuing shares to prescribed class of investors such as venture capital companies/funds or to any non-resident or to any specified company4, or (b) whose aggregate capital size (i.e., capital + premium) does not exceed INR 250 mn (c. USD 3.6 mn) issuing to any resident investor(s) other than those covered in (a).  The qualifying Startups also have to comply with certain restrictions such as non-deployment of funds in prescribed assets5 for a period of 7 years from issue of shares at premium.  

The Union Budget 2019 presented on July 5, 2019 clarified that for eligible Startups, except for basic KYC verification and documentation, there would be no scrutiny from tax authorities qua valuation of share premiums.  Besides, for eligible Startups incorporated as privately held companies, it provided i) exemption from valuation rigours of Section 56(2)(viib) for shares being issued to Category II – Alternative Investment Funds and ii) relaxation of norms for carry forward of losses for income tax purposes in the event of change of shareholding.  For those Startups who have been served notices and are grappling with tax demands w.r.t share premium, special administrative arrangements shall be made by Central Board of Direct Taxes for pending assessments of Startups and redressal of their grievances.  It will be ensured that no inquiry or verification in such cases can be carried out by the Assessing Officer without obtaining approval of his supervisory officer. 

1. Way Forward 

While Startup Notification does reflect the Government’s intention on extending relief to Startups,  certain aspects such as denial of benefit for Startups that have already received demand notices, onerous restrictions on investment of funds, modest overall (capital + premium) limit of INR 25 crores for claiming exemption, etc. continue to be a concern.  Dynamic startups requiring huge capital (in excess of INR 250 mn (c. USD 3.6 mn)) may still be found wanting with respect to satisfying certain conditions in order to claim such exemption from rigours of taxation u/s 56(2)(viib) of IT Act.  While Union Budget 2019 does move in that direction to provide significant relief to the overall ecosystem of startup investments, a lot remains to be addressed to reduce inconsistencies and rationalize the Startup framework in India.