Income Tax Exemption for Angel Investors in Startups

On 24th May 2018, the Indian government acknowledged a long-standing demand of the startup community in the country, announcing that the angel investors would receive a total exemption on the investments in the startups. Angel investors were taxed heavily, even when the foreign investors and venture capital firms were exempt from it. Angel Investor is one who invests his money in a startup while it is still finding its feet and still struggling to establish itself in the marketplace.

Up until now, an angel tax of more than 30% was levied on the funds invested by the individuals in an unlisted firm at the share price above the fair market value. Usually, around 300-400 of the start-ups fund themselves with the angel funding in a year.

The Income Tax Department has exempted the Angel investors, subject to specific conditions that are laid down by the Indian Department of Industrial Policy and Promotion (DIPP), which has offered substantial relief to early-stage investors.

Points to ponder

• The income tax relief impacts the startups which are approved by the inter-ministerial panel, where the paid-up capital and share premium of the beneficiary company doesn’t exceed INR 10 crore after the issuing of shares. This notification is effective retrospectively from 11th April 2018.

• Angel investors planning to subscribe shares in a startup would require fulfilling specified criteria and the start-ups would need to procure the report from the merchant banker which would specify the fair market value of such shares as per the income tax rules.

• As per the income tax notification, angel investors with the minimum net worth of INR 2 crore or the average returned the income of more than INR 25 lakhs in the previous 3 financial years will be eligible for 100 % tax exemption on the investments that are made in the start-ups above the fair market value.

• Many startups have raised their concerns over taxation of the angel funds under the provisions laid down under Section 56 of the Income Tax Act, 1961. This section required taxing the funds received by an entity. Around 18 start-ups received the notices from income tax authorities. Start-ups that are incorporated on or before April 2016 could seek the exemptions from this section.

• However, the 3-year income tax concession is available to the startups that have been incorporated after 1st April 2016. Start-ups enjoy the income tax benefit for 3 out of 7 successive AYs (assessment years) under the Income Tax Act. The Indian government so far has extended the tax benefits to only 88 startups which have been recognized by Department of Industrial Policy and Promotion since January 2016. For availing both the concessions i.e. exemption from tax on funds and exemption of tax from 3 years, start-ups need to approach the inter-ministerial board of certification.

• The notification is considered a welcome move in dispelling fears of the start-ups with respect to angel tax and providing much-required clarity in relation to non-applicability of the angel tax. Further, this decision to provide an exemption to investors in start-ups from the income tax was intended to address a major issue that was faced by the angel investors who were investing their money during the early times of gestation and growth. This exemption will provide a level playing field for the investors.

• The other key takeaway was the amendment with respect to the issue of valuations reports by Chartered accountants for angel tax purposes. The Central Board of Direct Taxes (CBDT) has amended the Rule 11 UA (2)(b) of the Income Tax Act, 1961, thus making the valuation by merchant bankers compulsory for determining the fair market value of the unquoted equity shares.