What is Angel Tax and Why it is Levied?

What is Angel Tax

Angel tax is a tax levied on the premium amount received by unlisted companies when they issue shares to angel investors. This concept was introduced in 2012 under Section 56(2) (vii b) of the Income Tax Act. The primary purpose of angel tax is to address the issue of money laundering through inflated share valuations. This tax is applied when the amount raised exceeds the fair market value of the shares, with the premium being treated as "income from other sources" and taxed accordingly​.

Why Angel Tax is Levied?

Angel tax was introduced primarily to prevent money laundering. Before its introduction, there were concerns that some companies were laundering money by issuing shares at a highly inflated price. By taxing the excess premium, the government aimed to curb this practice and ensure transparency in the valuation of shares. The tax applies to the difference between the face value of the shares and the amount actually paid by the investors. For instance, if a company issue shares with a face value of ₹10 each but sells them for ₹20, the additional ₹10 is subject to angel tax​.

Importance of Angel Tax

1. Preventing Money Laundering: The primary importance of angel tax is its role in preventing money laundering. By scrutinizing and taxing the excess premium on share valuations, the government can reduce the chances of unaccounted money being funnelled through inflated investments.
2. Ensuring Fair Valuation: Angel tax encourages fair and transparent valuation practices. It pushes companies to provide a more realistic valuation of their shares, which helps in maintaining market integrity and investor confidence​.
3. Revenue Generation: By taxing the excess premium, the government generates additional revenue. This revenue can be used for various developmental activities and public welfare programs​.

Changes in Angel Tax Regulations in Union Budget 2024

In recent years, there have been significant changes in angel tax regulations. One notable change in the 2023 budget is the extension of angel tax to foreign investors. Previously, the tax was only applicable to investments made by domestic investors. The new regulation means that any excess premium received from foreign investors will also be taxed. This change has raised concerns among startups as it could potentially deter foreign investment, which is crucial for their growth and development​.

Exemptions and Challenges in Angel Tax

While angel tax is designed to curb illicit practices, it has also posed challenges for genuine startups. To address this, the government has introduced exemptions for certain startups. To be eligible for these exemptions, startups must be recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) and have a paid-up capital of ₹25 crores or less. Additionally, they must not invest in certain assets like land, jewellery, or shares within seven years of issuing the shares​.

Despite these exemptions, startups still face challenges. Valuation discrepancies often arise because the fair market value (FMV) of a startup is difficult to determine. Investors may pay a premium based on the startup's potential and innovative ideas, which tax officials may not recognize. This discrepancy can lead to disputes and additional tax burdens on startups​.

Impact on Startups Due to Recent Changes in Angel Tax

The introduction and subsequent changes to angel tax have had a significant impact on startups in India. While the tax aims to ensure fair valuation and prevent money laundering, it has also created hurdles for startups seeking investment. The extension of angel tax to foreign investors has raised concerns about a potential decline in foreign funding, which is vital for many startups. According to reports, funding for Indian startups dropped by 33% in 2022 compared to the previous year, highlighting the challenges posed by such regulations​​.

Startups argue that the angel tax creates a financial burden and stifles innovation. The tax makes it difficult for startups to justify their valuations, as they are often based on future potential rather than current earnings. This can discourage angel investors, who are crucial for providing early-stage funding to startups. Additionally, the tax can create cash flow problems for startups, as they have to pay the tax upfront, even if they have not generated significant revenue.

The Role of Angel Investors

Angel investors are wealthy individuals who provide capital to startups in exchange for equity or convertible debt. They play a crucial role in the startup ecosystem by offering not only financial support but also mentorship and industry connections. Angel investors take significant risks by investing in early-stage companies that have high growth potential but also high chances of failure. Their involvement can be pivotal in the success of a startup, providing the necessary resources and guidance to help the company grow.

Proposed Amendments and Future Outlook

The Finance Bill, 2023, proposed amendments to the existing angel tax regulations, aiming to include foreign investors within its scope. This means that if an Indian startup raises funding from a foreign investor, the excess premium will be taxed as income. While this aims to create a level playing field and prevent money laundering, it has raised concerns among startups about its impact on foreign investment. Startups fear that this could lead to a decrease in foreign funding, which is crucial for their growth and expansion​.

Importance of Regulatory Clarity

For startups to thrive, it is essential to have clear and supportive regulatory frameworks. The ambiguity and complexity of the current angel tax regulations can create uncertainties for both startups and investors. There have been calls for more clarity and simplification of these regulations to foster a more conducive environment for startups. This includes clear guidelines on valuation methods, exemption criteria, and streamlined processes for tax assessments and disputes​.

Conclusion

Angel tax is a crucial regulatory measure aimed at preventing money laundering and ensuring fair valuation of shares. While it serves an important purpose, its implementation has not been without challenges. Startups often struggle with valuation disputes and the potential impact on foreign investment. However, exemptions and ongoing regulatory adjustments aim to balance these challenges, promoting a fair and transparent investment environment for startups in India.

The future of angel tax regulations will likely continue to evolve as the government seeks to balance the need for preventing financial malpractices with the growth and development of the startup ecosystem. For startups, navigating these regulations will require a clear understanding of the tax implications and proactive measures to ensure compliance while attracting the necessary investment to fuel their growth​