Insights

Introduction: Understanding Angel Tax
Angel Tax refers to the income tax levied on the capital that unlisted companies, particularly startups, raise through the issuance of shares to investors at a price exceeding the fair market value. The excess amount is treated as “income from other sources” and taxed accordingly. This tax was introduced in 2012 under Section 56(2)(viib) of the Income Tax Act, 1961, with the primary aim of curbing money laundering and preventing the inflow of unaccounted funds into startups. 

The Shift: From Burden to Relief
The Angel Tax was introduced in 2012 as an anti-abuse measure to curb money laundering disguised as startup investments. However, this strict policy soon became a barrier to India’s startup ecosystem, making fundraising difficult for budding entrepreneurs. Recognizing the challenges, the government introduced exemptions in 2016 for startups registered with the Department for Promotion of Industry and Internal Trade (DPIIT), providing relief from Angel Tax.

Despite these relaxations, the Rs. 25 crore threshold was frequently exceeded, making many startups ineligible for exemptions. Additionally, valuation disputes led to further complexities. In 2017, new rules mandated that the startup’s valuation be determined using either the prescribed valuation method (as per Income Tax rules) or an alternative valuation that could be justified to the Assessing Officer.

Until April 1, 2023, Angel Tax applied only to investments from domestic investors. Companies could determine the fair market value (FMV) of shares using either the Adjusted Net Asset Value (NAV) method or the Discounted Free Cash Flow (DCF) method, opting for the higher valuation. However, even with exemptions for DPIIT-registered startups and Category I & II Alternative Investment Funds (AIFs), a significant portion of startups remained outside the relief framework due to stringent compliance conditions.

In 2023, the Angel Tax provisions were extended to investments from non-resident investors, adding further complications. New valuation methodologies were prescribed, leading to increased uncertainty for startups and investors alike.

Recognizing these persistent issues, the Union Budget on July 23, 2024, officially abolished Angel Tax across all categories of investors. This move was seen as a landmark decision to boost India’s startup ecosystem and attract global capital.

Impact of the Exemption on Startups and Investors
The abolition of Angel Tax is anticipated to have a profound positive impact on both startups and investors:

• Enhanced Investment Flow
  With Angel Tax no longer in place, domestic and international investors will find it more appealing to fund Indian startups. Earlier, the tax acted as a deterrent, making investors hesitant due to potential tax liabilities. The removal of this tax will likely lead to an increase in venture capital (VC) and angel investments. Startups, especially early-stage ones, often struggle to raise funds due to high compliance costs. The removal of Angel Tax reduces this financial burden and encourages investors to back high-potential startups without fearing tax scrutiny.

• Simplified Valuation Processes
  One of the major concerns with Angel Tax was the frequent disputes regarding share valuations. The valuation methodologies used by startups often differed from those recognized by tax authorities, leading to unnecessary litigation and financial strain. The exemption eliminates these valuation disputes, creating a more investor-friendly environment. Now, Investors will have the flexibility to negotiate valuations based on market demand and company potential, rather than worrying about compliance with strict tax regulations.

  Moreover, with less tax-related uncertainty, startups might explore innovative fundraising approaches, such as convertible notes, SAFE (Simple Agreement for Future Equity), and revenue-based financing, all of which were previously complicated due to Angel Tax implications.

• Boost to Entrepreneurial Spirit
  Previously, many startups had to allocate significant resources to legal and tax consultations to comply with Angel Tax regulations. With the removal of this tax, entrepreneurs can now focus on product development, market expansion and hiring talent instead of dealing with bureaucratic hurdles. Angel investors, who typically invest in early-stage startups, often faced excessive scrutiny due to the Angel Tax. The exemption will now incentivize more high-net-worth individuals (HNIs) and institutional investors to take risks on promising startups.

Challenges Ahead
While the abolition of Angel Tax is a positive step, certain risks and challenges must still be addressed to ensure its effective implementation and prevent misuse.

• Ensuring Compliance
  While the Angel Tax exemption offers significant benefits, there are still concerns regarding financial mismanagement, compliance and transparency. The government must ensure that startups maintain proper documentation and financial disclosures to prevent fraudulent activities. Regular audits and monitoring of capital inflows will be essential, and regulatory bodies like the Income Tax Department and SEBI may introduce alternative compliance measures. 

• Preventing Misuse of the Exemption
  While the removal of Angel Tax offers significant benefits, it also introduces the risk of misuse, particularly in the form of shell companies and money laundering. To prevent this, authorities must implement stricter monitoring mechanisms to detect fraudulent activities and ensure that only genuine startups benefit from the exemption.

  Moreover, clear eligibility criteria for startups should be established, with agencies like the Department for Promotion of Industry and Internal Trade (DPIIT) playing a key role in verifying and regulating eligible companies. 

Global Insights
To better understand how India can refine its tax policies to foster startup growth, it is useful to examine the frameworks adopted by other countries like the United States, the United Kingdom and Singapore. For instance, the U.S. has created a startup-friendly environment through policies like the Qualified Small Business Stock (QSBS) exemption. This allows investors to exclude gains from taxable income if they invest in eligible startups. This tax incentive encourages early-stage investments, supporting the growth of emerging companies. The QSBS provision, under Internal Revenue Code Section 1202, gives investors the opportunity to shield up to 100% of their capital gains from federal income taxes on qualifying small business stocks, creating a more appealing environment for investment.

While, in the U.K., the government offers several tax relief schemes aimed at stimulating investment in startups, such as the Seed Enterprise Investment Scheme (SEIS) and the Enterprise Investment Scheme (EIS). These initiatives provide tax reliefs to investors who back qualifying startups, significantly reducing their tax burdens and encouraging a higher volume of investments in early-stage companies, thereby promoting innovation and entrepreneurship.

Also, Singapore’s tax policies are highly favorable for startups, offering exemptions on capital gains and maintaining a low corporate tax rate. In addition, the country supports startups through various grants and incentives aimed at key sectors. These policies create a competitive edge, attracting both local and international investors, and making Singapore an attractive hub for startups to thrive.

The Way Forward
The abolition of Angel Tax is a significant milestone in India’s efforts to strengthen its startup ecosystem. However, its success depends on the careful implementation of additional measures to ensure the continued growth and sustainability of startups. The government will need to regularly assess the effects of the Angel Tax exemption to determine whether it is achieving its goals without leading to unintended consequences such as misuse by fraudulent entities. 

Additionally, alongside the tax exemption, the government must continue to develop infrastructure that supports startups, including access to funding, mentorship, and streamlined regulatory processes. This will provide startups with the necessary tools for scaling and long-term success. By focusing on these areas, India can solidify its position as a global hub for innovation and entrepreneurship driving sustained economic growth and offering a model for other nations to follow.