This Article has been authored by Suman Kumar Jha (Founder & Managing Partner), Afnaan Siddiqui (Co-Founder & Partner), Visakha Raghuram (Associate) and Bharat
INTRODUCTION
The abolition of the Angel Tax in the 2024 budget for all classes of investors represents a significant reform that will benefit India’s startup ecosystem. Introduced in 2012 under Section 56(2)(viib) of the Income Tax Act, the Angel Tax aimed to curb money laundering by taxing unlisted companies on capital raised above the fair market value (FMV) of shares. This tax, targeting the difference between the share issue price and FMV, posed challenges for startups, which often had difficulty justifying their valuations based on future projections.
Despite several exemptions and amendments over the years, such as exemptions for DPIIT-registered startups and various valuation methods, the fundamental issues persisted. The tax burden and compliance requirements hindered the growth and investment potential of startups. The 2023 extension of these provisions to include funds received from non-resident investors further complicated the situation.
The 2024 budget’s decision to abolish the Angel Tax aims to reduce compliance burdens and financial strains on startups, thereby enhancing the ease of doing business, fostering domestic capital formation, and contributing to job creation and technological advancement. It is expected to boost investor confidence, attract more capital to the startup ecosystem, and position India as a more attractive destination for entrepreneurs and investors, fostering a vibrant and dynamic entrepreneurial environment.
HISTORICAL BACKGROUND
Angel tax was introduced through a financial amendment in 2012, specifically under Section 56(2)(viib) of the Income Tax Act, 1961 aimed at curbing money laundering practices. Under this provision, any unlisted company (typically startups) receiving investments exceeding the fair value of their shares must treat the surplus as ‘income from other sources,’ which is then taxed. Since this tax predominantly affects angel investors i.e., those who invest in startups—it has come to be known as the angel tax.
Owing to such stringent regulations, start up investing in India had taken a slight downturn as the investing to tax ratio was not in favour of the investors as commented by most VC funding companies. Recognizing this, the government relaxed the regulations, exempting startups registered with the Department of Industrial Policy and Promotion (DIPP) from the angel tax in 2016. However, the lower prescribed threshold limits were often exceeded by startups. To address conflicting opinions on valuation of start-ups, Companies (Registered Valuer and Valuation) Rules were established in 2017, stipulating that the value of a start up would be determined based on the higher value calculated according to prescribed rules or the value that could be justified to the satisfaction of the Assessing Officer.
In 2023’s finance bill, there were certain changes to the law that ultimately resulted in a very slow growth for the start-up and VC funding sphere, the bill proposed to include foreign investors in the tax ambit, meaning that funding raised from foreign investors will now be counted as taxable income for startups. For instance, if a startup’s fair market value per share is Rs 10, and they offer it to an investor for Rs 20 in a subsequent funding round, differenential Rs. 10 would be taxed as income. This is significant as foreign investors, have been crucial in funding startups, with investments in over a third of India’s unicorns—privately held startups valued at $1 billion or more. This reduced the financing available to startups, already experiencing a funding winter since 2022 when funding dropped by 33% to $24 billion. The additional tax liability was considered to repel foreign investors, pushing more startups to relocate overseas.
India, having the third-largest startup ecosystem globally, has seen consistent annual growth of 12-15%. Cities like Bangalore rank among the world’s top 20 startup cities and one of the fastest-growing ones. Government initiatives like the Startup India Initiative, which recognized over 69,000 startups by May 2022 across diverse sectors such as IT, health, education, agriculture, and food, have been crucial. This initiative has enhanced infrastructure, facilitated easier patent filings, improved regulatory environments, and provided economic stimulus through a INR 10,000 crore Fund of Funds managed by SIDBI. Government data shows startups under this initiative employed about 1.74 lakh people in 2021. Additionally, the Start-Up India Programme aims to build a robust ecosystem for innovation and large-scale employment, with the Start-up India Digital Platform being the world’s largest virtual incubator. The advantages offered by such government policies was offsetted by the high tax rates imposed on the investors, which ultimately caused detriment to the funding received by such start-ups.
A New Era for Startups: The Abolition of Angel Tax
In the recently proposed Annual Budget for the financial year 2024-25, the Union Government announced the abolition of the Angel Tax. The primary goal of this move is to strengthen the startup ecosystem and promote entrepreneurship.
Removing the angel tax is a pivotal move that could potentially transform the Indian startup ecosystem. This move is set to bring numerous benefits. First, it will likely lead to increased investment, as investors now have a greater incentive to support promising startups without the burden of the tax. This surge in angel investments is expected to fuel the growth of young companies. Additionally, the abolition of the angel tax simplifies processes for startups, eliminating the need to navigate complex exemption procedures and freeing up valuable time and resources for core business functions.
With more accessible capital, startups can prioritize research and development, spurring innovation across various sectors. This not only benefits the startups themselves but also contributes to India’s overall economic growth. Furthermore, removing the angel tax enhances India’s global competitiveness, making it a more attractive destination for international investors. This influx of investment and international exposure will strengthen the Indian startup ecosystem and position it to compete effectively on the world stage.
However, while abolition of angel tax is certainly a step in the right direction a few suggestions can be taken from the taxation systems in countries like the United Kingdom, where ‘Enterprise Investment Scheme’ or (EIS) and ‘Seed Enterprise Investment Scheme’ (SEIS) was introduced for the benefit of investors to encourage more investment into start-ups.
The Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) provide significant tax reliefs to investors in the UK. EIS offers benefits such as 30% Income Tax relief on investments up to £1 million annually, capital gains tax exemption on profits from EIS shares held for at least three years, the ability to offset losses against income tax, capital gains tax deferral, and inheritance tax exemption on shares held for at least two years. Investors must be UK taxpayers, holding no more than 30% of the company’s shares, not be employed by the company unless they’re a director, and not receive any benefits other than their return on investment.
SEIS, aimed at even earlier-stage companies, provides 50% income tax relief on investments up to £200,000 annually, capital gains tax exemption on profits from SEIS shares held for at least three years, and capital gains tax reinvestment relief where investors can claim relief on 50% of the reinvested gains. Both schemes aim to promote investment in startups by reducing tax burdens on investors, thereby encouraging more funding into these early-stage companies. Investors can access EIS and SEIS businesses through various platforms, including direct investments, EIS funds, and trusts.
Adopting similar schemes in India could be highly beneficial for the country’s burgeoning startup ecosystem. These schemes provide substantial tax incentives to investors, which could significantly boost early-stage funding for startups. By offering income tax relief, capital gains tax exemptions, and the ability to offset losses against income tax, such schemes would make investing in startups more attractive. This could lead to an influx of capital, enabling startups to invest more in innovation, research, and development, thereby accelerating their growth and contributing to overall economic progress. Furthermore, the simplification of tax processes and the reduction of financial risks for investors would enhance the ease of doing business in India, attracting both domestic and international investors. This, in turn, would foster a more dynamic and competitive entrepreneurial environment, positioning India as a global hub for innovation and technology.
Previously, the angel tax posed significant hurdles for startups seeking funding. It discouraged investment by making angel investors hesitant to support young companies due to the additional tax burden. This limited the pool of potential investors and restricted the flow of much-needed capital. Additionally, the compliance process for angel tax exemptions involved complex regulations and bureaucratic red tape, adding unnecessary stress and diverting focus from core business activities.
The abolition of the angel tax is a positive step for the Indian startup ecosystem, promising increased investment, simplified processes, and a greater focus on innovation and global competitiveness. The removal of this tax burden will help startups thrive, fostering a more vibrant and dynamic entrepreneurial environment in India.