In June 2016, the Central Board of Direct Taxes (CBDT) repealed angel tax for startups. This article provides an overview on the same.
What is Angel Investment?
Investment in equity shares of startup companies by investors is called angel investment. Such investors who invest in the equity shares of startup companies are called Angel Investors. Angel investors are essentially the high net worth individuals/firms/companies that used to form a group of investors for investment in startup companies or small entrepreneurs.
What is angel investment tax?
Angel Investment tax (or simply angel tax) was introduced in 2012 Union Budget.
In simple terms, capital raised by an unlisted company against an equity issue of shares in excess of the fair market value is taxable in the hands of the companies as “income from other sources” under Sec 56 (2) of the Income Tax Act and charged at corporate tax rate. The purpose is to curb the inflow of black money into start-ups under the guise of angel investments.
Section 56(2)(viib) analysis
Refer the entire provision of the section at the end of the article under the head appendix. The important points are:
- It is applicable to domestic unlisted companies only. LLPs not covered.
- The investor must be resident. Investment from abroad not covered.
- Only the equity issue is covered. The funds could be raised by issuing convertible debentures.
- Fair market value has to be determined either using Net asset Value Method or Discounted Cash flow method as per rule 11UA of Income Tax Rules.
- Consideration not defined. Since intent was to curb black money, it is supposedly to include cash transactions only.
- Law shall not apply where the consideration for issue of shares is received by a venture capital undertaking from a venture capital company / venture capital fund.
- Taxable event happens when the consideration received is more than the face value of shares, whereas, the taxability will happen, when the consideration received exceeds the fair market value of shares.
Implications of levy of angel tax
- Raising initial rounds of funding is hard for any company. The tax creates an unnecessary burden on start-ups
- Valuing startups based on their assets alone, given intangibles such as goodwill is not easy. Nor is it easy to arrive at a ‘fair value’ for them, based on discounted cash flows. So, startups are often valued subjectively and the valuation which seems sky-high to some, may be fair to others
- Early stage seed funding were often being subject to regulatory scrutiny and unfair taxation as FMV evaluation was undertaken.
Exemption of angel tax
The Central Board of Direct Taxes vide Notification no 45/2016 dated June 14, 2016 (CBDT Notification) had made the required changes in Section 56(2)(viib) of the Income- Tax Act, 1961 exempting startups raising funds from angel investors.
Remember, Investment in every startup is not eligible for the exemption.
Only such startups which fulfill the conditions specified under Startup India action plan (the DIPP notification number G.S.R. 180(E), dated the 17th February, 2016) is exempt. The riders are:
a) An entity is considered as a ‘startup’-
i. Up to five years from the date of its incorporation/ registration;
ii. If its turnover for any of the financial years has not exceeded Rupees 25 crore; and
iii. It is working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property;
b) Entity formed by splitting up or reconstruction of a business already in existence shall not be considered a ‘startup’
c) Startups would need to get a certificate from the Inter-ministerial Board of Certification to get the status of startup.
The said exemption will not apply to retrospective investments.
Thus the exemption does not being any massive relief due to multiple riders associated with definition of startup.
Provision of Sec 56(2)(viib)
“where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:
Provided that this clause shall not apply where the consideration for issue of shares is received—
(i) by a venture capital undertaking from a venture capital company or a venture capital fund; or
(ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf.
Explanation.—For the purposes of this clause,—
(a) the fair market value of the shares shall be the value—
(i) as may be determined in accordance with such method as may be prescribed; or
(ii) as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature,
whichever is higher;
(b) “venture capital company”, “venture capital fund” and “venture capital undertaking” shall have the meanings respectively assigned to them in clause (a), clause (b) and clause (c) of [Explanation] to clause (23FB) of section 10