Abolishment of Angel Tax – A welcome move

Co - Authored with Abhinav Aggarwal, Director M&A Tax, KPMG in India

In recent years, India has emerged as the third-largest hub for unicorn startups, surpassing many developed nations in global rankings. With an improving start-up landscape in India and the significant thrust provided by the Indian government through policy changes, it is anticipated that this trend will continue in the coming years, catalyzing India's goal of ‘Viksit Bharat’.

However, the sheen of this favourable run was dimmed by the controversial angel tax provisions introduced by the Government of India nearly a decade ago, with subsequent changes made from time to time to widen the tax bracket.

With this Budget, the Indian startup ecosystem heaved a sigh of relief as Hon’ble Finance Minister Nirmala Sitharaman announced the abolition of dreaded Angel taxation for all classes of investors. Before delving further into the impact of this proposal, it is important to understand the intent of introducing the provisions, the evolution of the provisions over the years, and the necessity for abolishment.

Brief history of legal provisions

Angel tax (i.e., section 56(2)(viib) of the Income-tax Act, 1961) was introduced vide the Finance Act 2012, seeking to tax any excess premium received by a closely held company upon the issue of shares. These were introduced as an anti-abuse provision to prevent the generation and circulation of unaccounted money through share premiums received from resident investors in a private limited company in excess of its fair market value (‘FMV’).

In 2016, to boost emerging start-ups, the Government relaxed norms, exempting startups registered with the Department of Industrial Policy and Promotion (‘DIPP’) from such angel tax. However, the lower prescribed threshold limits were easily crossed by start-ups.

Due to conflicting opinions on valuation, rules were established in 2017 wherein value shall be adopted based on the higher value calculated as per prescribed Rules, or the value that could be supported to the satisfaction of the Assessing Officer.

In 2023, these provisions were also extended to money received by an Indian company from non-resident shareholders. Further, new valuation methodologies were prescribed resulting in numerous complications.

Now, Budget 2024 proposes to abolish the angel tax provisions for all categories of investors.

Angel Tax – A demon for start-ups

Since its introduction, the interpretation of these provisions has been a topic of numerous debates among the corporates as various aspects remained unclear leading to controversies. This is further accelerated by Indian tax authorities rejecting the valuation methodology adopted by the taxpayer and adopting a contrary position while going beyond the intent of the legislation. A few issues include (a) failure of provisions to differentiate between legitimate investments and money laundering activities; (b) Tax officer rejecting the valuation methodology and undertaking fresh evaluation; (c) disparity with valuations prescribed under Foreign Direct Investment Regulations; (d) Valuation issues in case of issuance of shares by an Indian company in a distressed situation, right issues, bonus issues, amalgamation/demerger etc.; (e) applicability at the time of conversion of convertible instruments into equity, etc.

Given this, start-ups found it difficult to attract foreign investors due to the angel tax and uncertainty around it which deterred start-up growth.

The proposed amendment and issues to be addressed

Budget 2024 now seeks to abolish angel tax for all categories of investors with effect from AY 2025-26 (i.e., April 1, 2024; Financial Year 2024-25). Although specific amendments have been made in section 56(2)(viib), no corresponding amendment has been made in the definition of ‘income’ under section 2(24)(xvi). This seems to be an omission and clarification on this aspect is expected.

Nevertheless, this move certainly addresses the above-highlighted issues. Having said that, to further make an investment in a start-up a viable option, the Government may also seek to cater to the following issues:

Given the prospective annulment of the angel tax provisions, the resolution of disputes already pending before the courts requires careful consideration.

Relief from litigation on account of corroborating source of income of investment to the satisfaction of tax officers under provisions of section 68.

The proposal of Finance Bill 2024 to completely abolish angel tax provision across all investor classes will provide a much-needed breather to the Indian start-up ecosystem and provide an impetus for a fresh inflow of capital in the economy.

Making some changes to the legal framework will provide certainty and help Indian startups grow and expand. There are still many details that need to be worked out to support new startups, and making some policy changes in this area could greatly improve the overall environment.

A Version of this article was published by The Financial Express Online. The same can be read here.