Framework around ‘Angel Tax’ in India
Angel tax refers to a term used in some countries, particularly in India, to refer to a tax that may be imposed on the capital raised by unlisted companies, above the fair market value, through the issuance of shares to the investors. The intention behind introducing angel tax was to prevent money laundering and to scrutinize the valuation of shares issued by unlisted companies.
Under the Indian taxation regime, angel tax has been provisioned for under Section 56(2)(viib) of the Income Tax Act, 1961 (“IT Act”). Section 56(2)(viib) of the IT Act provides that where an unlisted company receives any capital from a resident of India[1] against the issuance of shares that exceeds the fair market value of such shares, then such excess amount shall be taxed as an ‘income from other sources’ to the company.
However, the applicability of Section 56(2)(viib) of the IT Act is exempted where the consideration for the issue of shares is received: “(i) by a venture capital undertaking from a venture capital company or a venture capital fund or a specified fund; or (ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf.”
Determination of Fair Market Value:
For the purposes of Section 56(2)(viib) of the IT Act, ‘fair market value’ (“FMV”) of the shares shall be the value, which is higher of,- (i) as may be determined in accordance with Rule 11U and Rule 11UA of the Income Tax Rules, 1962; or (ii) as may be substantiated by the company to the Assessing Officer.
Under Rules 11U and Rule 11UA of the Income Tax Rules, 1962, FMV can be determined only using either the discounted cash flow methodology or the net asset value methodology. A similar requirement for valuation is also provided under the Foreign Exchange Management Act, 1999 (“FEMA”), wherein the shares of an Indian company cannot be issued to a non-resident below the FMV. While the foreign exchange management laws do not provide for a specific method of valuation to be employed, the companies are required to adopt a valuation methodology which is accepted internationally.
The difference in the scope of valuation methodologies provided under the IT Act and the FEMA has narrowed down the options for non-resident investors to adopt a valuation methodology which can be employed for the determination of FMV.
Exempting ‘Startups’ from the applicability of ‘Angel Tax’
Angel Tax in India had faced significant criticism from various stakeholders, including startups, investors and other industry experts. The primary criticism was related to the subjectivity associated with determining the valuation of startups. Further, imposition of angel tax was believed to discourage the angel investments due to the complexities and uncertainties associated with the taxation.
A joint survey conducted by LocalCircles and the Indian Venture Capital Association (IVCA) in 2019 revealed that 73% (Seventy-Three Percent) of the startups that raised capital (till 2019) received at least one ‘Angel Tax’ notice.[2]
In response to the criticism and with a view to encourage the startup ecosystem in the country, the Department for Promotion of Industry and Internal Trade (“DPIIT”) issued a notification dated February 19, 2019[3] to exempt startups from the provisions of Section 56(2)(viib) of the IT Act (“DPIIT Notification”).
Paragraph 4 of the DPIIT Notification provided that ‘Startups’ shall be exempted from the provisions of Section 56(2)(viib) of the IT Act upon the fulfilment of the following conditions:
- Such startup shall be recognized by DPIIT;
- The aggregate amount of share capital and share premium of the startup after the issue of shares does not exceed Indian Rupees Twenty-Five Crores (excluding such share capital amount as received from a non-resident or a venture capital fund); and
- Such startup shall not have invested in a list of assets (as provided under the notification)[4].
The DPIIT Notification provides the following eligibility criteria for recognizing any entity as a ‘Startup’:
- The entity shall be not more than 10 (ten) years old from the date of incorporation/registration;
- Turnover of such entity for any of the financial year since incorporation/registration has not exceeded Indian Rupees One Hundred Crore; and
- The entity shall be working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth generation.
‘Angel Tax’ on capital infusion by non-residents
Originally, Section 56(2)(viib) of the IT Act was applicable only to such capital infusion in unlisted companies which was made by residents in India. However, the Finance Bill of 2023, introduced by the Finance Minister of India, proposed an amendment to Section 56(2)(viib) of the IT Act to extend the ‘angel tax’ applicability on companies receiving capital infusion, above the FMV, from non-residents as well. The amendment was introduced vide the Finance Act, 2023 with effect from April 01, 2024.
Though not effective as yet, the amendment has attracted substantial criticism from the stakeholders and the investors. It has been argued that the startup sector is already distressed with the funding winter, and the amendment will further stagnate the funding into the startup ecosystem.
CBDT proposal to change the ‘Angel Tax’ regime
Pursuant to the response from the industry and the advocating submissions of DPIIT on the Finance Act, 2023, the Central Board of Direct Taxes (“CBDT”), on May 19, 2023[5], has proposed the following changes in the angel tax regime:
Expansion of the methodologies for valuation:
Under the existing provisions of the Rule 11UA of the Income Tax Rules, 1962, valuation for the purposes of Section 56(2)(viib) can be done only using the discounted cash flow methodology or the net asset value methodology. However, the CBDT has proposed to include 5 (five) more valuation methodologies, for non-residents, in addition to the DCF and NAV methods of valuation. This move is expected to provide flexibility to the non-resident investors to use and rely on valuation methodologies adopted globally, also in line with the provisions of FEMA.
Corresponding valuation with notified entities:
Further, the proposal provides that if a company has issued shares to an entity notified by the Central Government, then the corresponding valuation may be considered as the FMV of such company for the purposes of Section 56(2)(viib), subject to the following conditions:
- The consideration from the such FMV does not exceed the aggregate consideration received from the notified entity; and
- The consideration from the notified entity shall have been received within a period of 90 (ninety) days of the date of issuance of shares which are subject matter of valuation.
Exemption from ‘Angel Tax’ for minor variation above FMV:
The CBDT has made a proposal to exempt the applicability of ‘angel tax’ under Section 56(2)(viib) of the IT Act for such issue of shares which is at a premium of up to 10% (Ten Percentage) of the FMV. The advancement has been made taking into consideration the forex fluctuation, bidding processes and variation in other economic indicators. This submission is expected to provide a much needed comfort to the companies by allowing them to desist unprecedented ‘angel tax’ notices for narrow variations in the FMV.
Notifying excluded entities:
Pursuant to the appeal for reassessment to the Finance Act, 2023 making the ‘angel tax’ provision applicable to companies receiving capital from non-residents as well, the CBDT has proposed to exclude the applicability to certain notified non-resident entities, as follow:
- Government and Government related investors such as central banks, sovereign wealth funds, international or multilateral organizations or agencies including entities controlled by Government or where direct or indirect ownership of the Government is 75% or more;
- Banks or entities involved in insurance business;
- Any of the following entities, which is a resident of a certain countries or specific territories having robust regulatory framework:
- Entities registered with Securities and Exchange Board of India as Category-I Foreign Portfolio Investors;
- Pension Funds created or established under the law of a foreign country or specified territory; and
- Broad based pooled investment vehicle or fund where the number of investors in such vehicle or fund is more than 50 and such fund is not a hedge fund or a fund which employs diverse or complex trading strategies.
This move to exempt certain categories of non-residents from the applicability of ‘angel tax’ is likely to create a balance between the true intention of the law i.e., to avoid money laundering, and the promotion of the startup and fundraising ecosystem in India.
[1] The term ‘being a resident’ has been omitted under Section 32 of the Finance Act, 2023
[2] https://yourstory.com/2019/02/indian-startups-angel-tax-notice
[3] https://www.startupindia.gov.in/content/dam/invest-india/Templates/public/198117.pdf
[4] Please see the Paragraph 4(3) of the DPIIT Notification