On July 23, 2024, Finance Minister Nirmala Sitharaman announced the abolition of the “angel tax” in the Union Budget, bringing relief to startups and their investors. This move is expected to foster a more supportive environment for new businesses in India. Here is a detailed look at what the angel tax is, its origins, and the impact of its removal.
The concept of angel tax was brought in through the Union Budget of 2012 by then Finance Minister Pranab Mukherjee. It was mainly aimed at preventing money laundering activities through investments in startups and catching fraudulent firms. Over time, however, it became a significant burden for legitimate startups seeking funding.
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Understanding Angel Tax
Angel Tax, previously known as Section 56(2)(vii b) of the Income Tax Act, was a tax imposed by the government on the capital that startups received from angel investors beyond the company’s fair market value. For instance, consider the case of a startup whose fair market value stood at Rs 1 crore and it raised Rs 1.5 crore; the excess amount of Rs 50 lakh would then get taxed at approximately 31%.
The premium that the investors paid was considered income by the tax authorities and was taxed. Not only the funds received from Indian investors but this tax was also applied, without any differentiation, to funds received from foreign investors as well.
Difference Between Angel Investors and Other Investors
Angel investors are those HNIs who invest their personal income in startups or small and medium-sized companies. As opposed to institutional investors, angel investors typically invest in the early stages of a startup, thereby taking higher risks for potentially higher rewards.
Why Startups Opposed Angel Tax
Many startups reacted sharply to the angel tax, terming it as highly draconian and unreasonable. Indeed, according to them, ascertaining with accuracy the fair market value of a startup is very difficult. The AOs often used the discounted cash flow method for doing this valuation, which according to startups was inclined to favour tax authorities.
Apart from this, startups also claimed to have received notices on taxes for the investments made several years ago. In some cases, the total tax and late payment fees even went above the actual investment amount. A 2019 survey by LocalCircles reported that more than 73% of start-ups which raised between Rs 50 lakh and Rs 2 crore had been slapped with angel tax notices by the Income-tax Department.
In the 2019 Union Budget, the government had relaxed the angel tax rules for those startups that were registered with DPIIT. But this was not a blanket relaxation. Only those ventures that got certified by an assortment of bureaucrats—the IMB—who made a call on the innovativeness and worthiness of startups qualified for this exemption. As a result, fewer than 1% of the 84,000-odd DPIIT-registered startups got IMB certification.
Scrapping angel tax is a great respite to startups and investors. It also eliminates the uncertainty and financial burden associated with the tax, thereby making fundraising exercises easier for startups. This move is expected to attract more investment into the startup ecosystem, fostering innovation and growth.
