Angel Tax

What is Angel Tax?

 

Angel tax is a term used to refer to the income tax payable on capital raised by unlisted companies via issue of shares where the share price is seen in excess of the fair market value of the shares sold. The excess realization is treated as income and taxed @30%.

The tax was introduced in the 2012 Union Budget by then finance minister Pranab Mukherjee to arrest laundering of funds. It has come to be called angel tax since it largely impacts angel investments in startups.

 

Why Is Angel Tax Problematic?

There is no definitive or objective way to measure the ‘fair market value’ of a startup. Investors pay a premium for the idea and the business potential at the angel funding stage. However, tax officials seem to be assessing the value of the startups based on their net asset value at one point. Several startups say that they find it difficult to justify the higher valuation to tax officials.

In a notification dated May 24, 2018, the Central Board of Direct Taxes (CBDT) had exempted angel investors from the Angel Tax clause subject to fulfillment of certain terms and conditions, as specified by the Department of Industrial Policy and Promotion (DIPP) now renamed as the Department for Promotion of Industry and Internal Trade. However, despite the exemption notification, there are a host of challenges that startups are still faced with, in order to get this exemption.

 

Is An Exemption Available From Angel tax?

The government issued a notification in April 2018 to give exemption to startups under Section 56 of the Income Tax Act in cases where the total investment including funding from angel investors does not exceed Rs 10 crore. For the exemption, startups were also required to get approval from an inter-ministerial board and a certificate of valuation by a merchant banker. According to the notification, the exemption would apply only when the angel investor had a minimum net worth of Rs 2 crore or an average returned income of over ? 25 lakh in the preceding three financial years.

Why Has The Industry Raised The Issue Of Valuation Of Startups?

The share issued to an investor has to be valued to decide whether the price is in excess of fair value. The industry has demanded that the discounted cash flow (DCF) method of valuation be used to calculate angel tax instead of the net asset value (NAV) method, though even that may not capture the true value of a startup. The valuation of a startup is usually based on a commercial negotiation between the company and the investor and is a function of the company’s projected earnings at that point in time. However, since startups operate in a highly uncertain environment, many companies are not always able to perform as per their financial projection. Equally, some companies exceed the projection by a long mile if they are doing well.

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