Angel Tax Removal: A Boon for Startups?

The recent announcement by Finance Minister Nirmala Sitharaman to abolish the so-called "Angel Tax" has been widely welcomed by the startup ecosystem. Before celebrating, it's essential to understand what this move means, its benefits and any potential downsides.

1. What is Angel Tax

" ....I propose to abolish the so called Angel Tax for all class of Investors." said our FM in para. 153 under the heading 'Employment and Investment'. Two key points to note here are

A. So called (angel tax) and B. All (class of investors).

For sub-point A. Basically it's 'so so-called' angel tax because. The word 'Angel tax' is used nowhere in income tax act. It refers to the tax imposed under Section 56(2)(viib) under 'Income from Other Sources'. This section states that if a startup receives funding at a valuation above its Fair Market Value (FMV), the difference is taxable.

For sub-point B. We will discuss this in the 4th point.

2. Why angel tax is so bad.

Let's say I own a banana chips business valued at ₹10 crores. I want to raise funds from an investor, such as Nikhil Kamath (Zerodha founder). He agrees to buy 20% equity for ₹5 crores, valuing my business at ₹25 crores. The government would then treat the excess amount over the FMV as my income. For 20% equity at the current FMV, the value is ₹2 crores. Therefore, the taxable amount would be ₹5 crores - ₹2 crores = ₹3 crores.

The tax rate here is 30% plus 3% cess, resulting in a total tax rate of 30.9%. Hence, the tax liability would be ₹3 crores * 30.9% = ₹92.7 lakhs.

Since this tax is not based on actual income but on the valuation difference, it discourages both business owners and investors, negatively impacting fundraising for startups.

3. If Angel Tax is so bad, why was it introduced in the first place?

The primary intent behind introducing Angel Tax was to curb the practice of converting black money by investing in shell companies. This was a genuine concern of the government, but the 'Angel Tax' was not the right way to address that problem.

4. Why did the government take so long to abolish it?

Although the government took steps to relax the Angel Tax provisions in 2019, the exemption was only available under specific conditions:

• The startup must be recognized by the Department for Promotion of Industry and Internal Trade (DPIIT).
• The total paid-up capital should be less than or equal to ₹25 crores, excluding consideration received from non-resident investors, venture capital funds, and venture capital companies.
• A certified merchant valuer must determine the startup's FMV.
• Angel investments should be from foreign investors, not resident investors.
• The startup should not invest in specified assets within 7 years of issuing shares (e.g., land, loans, capital contributions to other entities, high-cost transport, jewelry, archaeological collections, and shares and securities).

Many startups did not meet these criteria and were still subject to Angel Tax. This is why the FM emphasized "all classes of investors" in her speech, acknowledging that the previous exemptions were insufficient.

Conclusion

According to point 23 of the Finance (No. 2) Bill, 2014, Section 56(2)(viib) was amended to state that Angel Tax would not apply from 1/04/2015. Therefore, startups receiving funding after 01/04/2024 can breathe a sigh of relief and focus on wealth creation for themselves and their investors, contributing to nation-building.

Thank you for reading. Suggestions for improvements are always appreciated.