Recently, there has been a lot of hue and cry around “Angel Tax” that many start-ups have been asked to pay. With a fresh batch of tax notices sent out to several start-ups last month, start-up communities country-wide have been lobbying for a roll back of the legislation that puts considerable tax burden on these new businesses.
What is the Angel Tax?
The Angel tax was first introduced in the Finance Act 2012 and refers to section 56(2)(viib) of the Income Tax Act, 1961. It is a tax at the rate of 30.9% on the value of investment received from ‘angel’ investors in excess of the fair value of such investment, by treating such excess as an income from other sources. Simply put, it is a tax on the share premium received by start-ups from Angel Investors.
Why it was introduced?
The Law was brought out to serve as a deterrent to unlawful money laundering activities routed through startups. By requiring further explanation, revenue authorities seek to identify those cases where the start-ups or the companies in question have been created merely to evade taxes or park unscrupulous funds and do not have a definite business model in place.
Friction arises because the calculation of the Fair Market value is left to the better judgment of the Revenue officers. The Tax Authorities oftentimes undervalue intangibles such as goodwill and Intellectual Property, while arriving at the fair market value, considering them excessive, resulting in a wide gap between the invested amount and fair market value of such amount. For most start-ups, valuations are based on future cash flows. Hence, even though these companies barely break-even in the present day, because of future prospects investors are willing to invest at significantly higher valuations.
The Angel Tax has had the entire Indian start-up community worried. Even those start-ups that have not yet received a notice from the Revenue Authorities and have raised money through angel investors are beginning to dread the tax notice since it could be sent to them eventually and they would have to explain the potential value of a business idea that is still at a very nascent stage. Hardships also arise because of the inadequate understanding of the start-up ecosystem on the part of the tax authorities. In some cases, the tax authorities are known to have disregarded even certified valuations by chartered accountants and registered valuers.
In order to sieve out the fraudulent cases and provide relief to the genuine start-ups, the Government has, overtime brought out several clarifications and relaxations. In April 2018, the Department of Industry Policy and Promotion (DIPP) along with the tax department released a clarification that exempted those entities covered in the definition of startups as per the DIPP. Thus, start-ups whose total investments (including funding from angel investors) do not exceed Rs. 10 crores have been excluded from the purview of the angle tax. On December 31, 2018, the Government issued a notification clarifying that fresh issue of shares at a premium will be left out from the tax ambit. The Central Board of Direct Taxes (CBDT) also issued a directive to the tax officers to not use coercive methods to recover the taxes that start-ups have been asked to pay by the 31st March, 2018. Despite the many reliefs offered, several genuine cases still fall under the non-exempted category and bear the brunt of the tax officers following the notices and hearings.
While, the tax was aimed at curbing money laundering activities, it threatens to kill entrepreneurial activity within the country, with some bonafide start-ups, to whom these notices have been sent, contemplating shutting down their operations. Tax at the maximum marginal rate of 30% is a substantial burden for these start-ups which are yet to see a spurt in their cash revenue. To avoid the tax implications, some potential businesses are even considering registering outside India where the regulations are more supportive of start-ups. In the age of ‘Make in India’ and ‘Startup India’, the angel tax is a major setback for budding entrepreneurs. In some cases even the angel investors have been sent notices asking for explanations for the sources of the funds invested in these start-ups, u/s 68 of the Income Tax Act, 1961. This builds a level of reluctance for the Angel investors and serves a major setback for start-ups which rely heavily on angel funding. If start-ups are the way forward, then the instability affecting these businesses should be brought to the cognizance of revenue authorities and persons understanding the start-up ecosystem should be tasked with assessing the authenticity of the start-up valuations.
Dave, S. (2019, January 3). Relief for companies facing tax outgo over valuation premiums. Economic Times. Retrieved from: https://economictimes.indiatimes.com/markets/stocks/news/relief-for-companie-facing-tax-outgo-over-valuation-premiums-as-govt-issues-clarification/articleshow/67358284.cms
Venkatraman, H. (2019, January 2). I-T dept;s angel tax notice snips at Indian start-ups' flight forward. DTNEXT. Retrieved from: https://www.dtnext.in/News/Business/2019/01/02080715/1101382/IT-depts-angel-tax-notice-snips-at-Indian-startups-.vpf
Singh, J. (2019, January 1). Angel Tax ghost: Startups asked to pay tax by March-end. ENTRACKR. Retrieved from: https://entrackr.com/2019/01/angel-tax-ghost-startups-tax-march-end/
Government of India. Income Tax Act, 1961, Bare Act. Income Tax Department. Retrieved from: https://www.incometaxindia.gov.in/pages/acts/income-tax-act.aspx
Upadhyay, P. (2018, December 21). Startups in Uproar over Angel Tax: The Tax Department’s Point of View. Bloomberg Quint. Retrieved from: https://www.bloombergquint.com/law-and-policy/startups-in-uproar-over-angel-tax-the-tax-departments-point-of-view#gs.1FYWCW5c
Pai, S. (2018, December 10) On the Clipped Wings of Angel Tax. Inc42. Retrieved from: https://inc42.com/resources/on-the-clipped-wings-of-angel-tax/
Image source: Unicustax
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