Angel Tax: Exemption, Rate, Example

If you are an entrepreneur, you must be aware of the term "Angel Tax". Under section (56(2)(viib)) of the Income Tax Act, a startup in India is required to pay a definite sum in the form of tax. However, in the 2019 Union Budget, the government announced some relaxation. At the same time, to become eligible for angel tax exemption, it is necessary to meet certain conditions. 
In the subsequent sections, we will know about angel tax, what is its exemption, and other related information. Keep scrolling and learn more.

Budget 2024 Latest Update: 

Angel tax has been abolished with effect from FY 2025-26, for all investor classes to strengthen India's start-up ecosystem.

What is Angel Tax?

To operate an early-stage venture, every business needs funds. In this scenario, startups seek investment in exchange for equity because they lack tangible assets to offer as collateral. When a startup struggles to establish itself in the market, an angel investor can invest money in it. 

The Income Tax Act of 1961's Section 56(2)(viib) discusses the concept of angel tax. According to the Finance Act, 2012, in the IT Act, every startup (i.e., unlisted companies whose shares are not available for buying on the stock market) that receives funding from an angel investor must contribute a certain amount to the government. 

This tax comes into play if the total investment value exceeds the company's FMV or Fair Market Value. Investment greater than FMV is categorised as "income from other sources", and the tax imposed on it is called angel tax. However, as announced in the Union Budget 2024, Angel tax has been abolished from FY 2025-26 in order to fuel the growth of start-up eco system in India.

For a comprehensive understanding of the concept of angel tax, let us consider an example. Suppose your firm receives investment from an angel investor of Rs 15 crore, and the investor gets shares in exchange. But the total fair market valuation (FMV) of the shares issued is Rs 10 crore. The remaining Rs 5 crore is considered excess money and, therefore, taxable at a rate of 30.9%. 

The primary objective of this tax was to prevent money laundering issues. Only 2% of the population actually complies with tax requirements. Most new businesses don't keep up with the appropriate account books or show their assets correctly, leading to the creation of black money in India. Due to this flaw, the Income Tax department decided to tax the private companies on excessive share premiums received above the FMV. 

Drawbacks of Angel Tax

Take a look at some of the major drawbacks of angel tax:

• Angel tax is applicable to startups that are funded by a resident Indian.
• A startup earning an investment from venture capital and non-resident investors are not eligible for the deduction of angel tax.
• Startups tend to lose a significant amount of money in the form of taxes as angel tax requires them to share a significant part of the investment. 

Angel Tax Exemption

As discussed above, an angel tax causes a startup to lose a significant portion of its investment. The majority of startups cannot afford to lose this amount of money, especially in the initial phase. The introduction of this tax in the amendment has received much criticism from investors, entrepreneurs, and industry analysts. 

After startups made numerous pleas, the Indian Government implemented some relaxations in the 2019 Union budget. In this budget, the government stated that if the startup is registered under the DPIIT or Department for Promotion of Industry and Internal Trade, it would not be subject to such tax. 

However, to be eligible for DPIIT, the startup needs to send an application along with the necessary documents to the Central Board of Direct Taxes or CBDT. After CBDT approval, they will be exempted from paying angel tax.

Apart from this, there are some other criteria that your startup needs to fulfil to file the required declaration and returns for angel tax exemption. Take a look below for a brief overview.

• After issuing the shares, the startup's maximum paid-up capital and share premium should not exceed Rs 25 crore. 
• As per Rule 11 UA (2)(b) of the Income Tax Act of 1961, it is imperative for the merchant banker to evaluate the fair market value of the startup.
• The amount raised from venture capital firms, NRIs and other specific companies is not included in the calculation. The startup's yearly turnover should not be more than Rs 100 crore in any of the past fiscal years.
• As per the income tax notification, angel investors are eligible for a 100% tax exemption on investing in startups with higher fair market value. However, to avail of this exemption, the average income of angel investors should not be more than Rs 25 lakh and should have a net worth of Rs 2 crore in the previous 3 fiscal years. 
• From the date of incorporation of a business, it can reap the benefit of a tax holiday for three consecutive years. During this period, the startup is exempt from paying taxes. 

The Indian Government has abolished the Angel Tax for all classes of investors with effect from FY 2025-26. Finance Minister Nirmala Sitharaman also added that this move is aimed at bolstering the Indian start-up system, boosting the entrepreneurial spirit, and supporting innovation.

Angel Tax Rate in India 

India has a structured tax system that uses both proportional and progressive taxation depending on income and other different standards. In this nation, angel tax is levied at a hefty rate of 30.9% on investments received by a startup greater than its fair market value. New businesses seeking funding from investors must pay angel tax to the Income Tax Department.

Angel Tax Example

Angel tax has caused many problems for startups, as they lose a major chunk of their investment towards tax payments. For a brief understanding, let's consider an example:

Suppose your startup has managed to receive an investment of Rs 50 crore by issuing 1 lakh shares to an Indian investor at Rs 5000 each. The startup's fair market value is Rs 2000 per share. Henceforth, the fair market valuation of shares stands at Rs 20 crore. Then the startup needs to pay angel tax on the excess of fair market value, which is Rs 30 Crore (Rs 50 crore - Rs 20 crore). As a result, the amount of tax due on this transaction will be Rs 9.27 Crore (i.e., 30.9% on Rs 30 Crore).

Final Word

Despite the tax exemption given to startups and investors, the concept of angel tax faced much backlash. The imposition of angel tax has hampered the growth of numerous startups in India. Thus, the abolition of angel tax is seen as a huge reform and is expected to simplify the funding process and foster the country's start-up ecosystem.