The archaic Angel tax of Indian income tax act

Is there now a tax on doing good? Well, if you’re referring to Angel Tax, that’s not what it is. What we discuss today is a change the Government recently proposed in tax rules for investments made by Indian residents in startups, also known as Angel Tax. What is it?

Closely-held private companies receive equity funds from outsiders. When these investments are made at a premium to the fair price, tax laws have so far held that the amount raised in excess to the fair value is taxable. The amount is reckoned as “income from other sources” and taxed under Section 56 (ii) of the Income Tax Act. The rate of tax was a hefty 30.9 per cent. This was applied not just to mature private companies, but also to small startups that took early-stage investments from residents in India.

As startups have very few sources of mainstream funding, investors and startups lobbied for the tax to be removed. Already, funds sourced from non-residents and venture capital funds were exempt from this tax. Now, the Centre has moved to exempt investments made by Indian residents in companies certified as ‘innovative’ startups, from Angel Tax. To qualify, the venture must fulfil certain criteria on age (not more than five years old), turnover (not exceeding ₹25 crore), purpose (building new product or services), and method (technology or intellectual property). It must also be officially recognised as an ‘innovative’ startup by the Inter-ministerial Board of Certification.

Why is it important?

Angel Tax was, therefore, problematic for a few reasons. For one, valuing startups based on their assets alone, given intangibles such as goodwill is not easy. Nor is it easy to arrive at a ‘fair value’ for them, based on discounted cash flows. So, startups are often valued subjectively and the valuation which seems sky-high to some, may be fair to others.

Two, higher valuations when raising funds, are beneficial to founders as it means giving up less equity. But given the closed nature of these deals, there were concerns on whether there was creative financial planning happening. The tax was introduced as an anti-abuse provision in the 2012 Budget to curb attempts to launder undisclosed income. Now, the relaxation could signal the willingness to nurture innovative firms.

Three, as opposed to the idea of taxing angel investors, investors in countries such as US are actually offered tax benefits when they fund small companies. There are also ways for angel investors to save tax by re-investing gains from one small business into another venture. But in India, there was an element of suspicion over startup investments. Attempts to simplify the tax treatment are hence welcome.

Why should I care?

For startup founders, venture capital firms and overseas investors are the key sources of funds and angels typically make up a small portion of the capital. But who knows? The removal of the tax may encourage more participation by local investors and help a newbie entrepreneur make a pitch to the crorepati next door.

If you are a resident investor and wealthy enough to play angel, you still need to note that only certified startups are exempt from Angel Taxes. So far, given that the scheme to certify startups is yet to flag off, no startup has a readymade certificate. Experts expect only a few startups to file and given the requirements only 1-2 per cent may pass the test.

The bottomline

The change, while good, may help only a few startups take wing