What is Angel Tax? Impact on Startups and Investors in India

Startups require capital to fuel their growth and bring their ideas to life. They often raise funds from angel investors for these financial needs, who invest in exchange for equity. 

Angel Investing is crucial in supporting innovative startups during their early stages. However, when startups raise funds at a valuation higher than their fair market value, this amount is not fully tax-free under the Income Tax Act and becomes subject to Angel Tax.

In this blog, we will explain the concept of Angel Tax in simple terms and highlight all the key details you need to know.

What is Angel Tax?

Angel Tax is a tax levied on the money raised by startups by issuing shares to investors. In simple terms, when a startup receives funding from an investor and gives them shares in return, the government wants to ensure that this money is genuine and not being used to hide black money.

This tax comes under Section 56(2)(viib) of the Income Tax Act. If a startup issues shares to an investor at a price higher than the “fair market value” (FMV), then the extra amount is taxed as “income from other sources.”

For example, if a startup’s share value is ₹100 per official calculations, but an investor pays ₹150 for it, the extra ₹50 per share is taxed as income. This is what is called the Angel Tax.

Why was Angel Tax Introduced?

The main reason behind the Angel Tax was to stop the practice of money laundering — people showing black money as legitimate investments in startups. However, many genuine startups and honest investors also got trapped in these rules in trying to catch wrongdoers.

How Does Angel Tax Affect Startups?

Imagine being a young entrepreneur trying to raise funds to realize your dream project. Suddenly, you are hit with a heavy tax bill because the government thinks you overvalued your shares.

Here are some real impacts on startups:

• Reduces Funding Opportunities

Investors often shy away from investing in startups if they think the startup might get taxed heavily later. No one wants to get into trouble for trying to help a startup grow. This means less money for innovation and job creation.

• Cash Flow Problems

Startups usually operate with limited funds. Their available working capital is reduced when they are required to pay Angel Tax. This makes it challenging for them to hire talent, develop products, or invest in marketing and growth activities.

• Discourages High Valuation

Sometimes, startups have unique ideas or strong future potential. Investors may be willing to pay a premium (higher price) to own part of the business. But Angel Tax discourages this practice, making startups undervalue themselves to avoid tax troubles.

How Does Angel Tax Affect Investors?

Like startups, angel investors — those who invest their money in young companies — are also affected.

1. Higher Risk for Investors

Investors take big risks when they fund startups. If their investment is treated as taxable income for the startup, it creates unnecessary complications. This “investor tax” may push them away from startup investments and towards safer options like mutual funds or bonds.

2. Reduced Angel Investing Culture

India needs a strong angel investing culture to boost new businesses and ideas. But the Angel Tax makes people think twice before investing, and that’s not good for the economy.

Are There Any Exemptions from Angel Tax?

Yes, the government has provided some relief over the years.

1. Recognized Startups by DPIIT

Suppose a startup is registered with the Department for Promotion of Industry and Internal Trade (DPIIT). In that case, it may get an exemption from Angel Tax, but only if specific conditions are fulfilled. 

These include being recognized as an eligible startup, not investing in certain specified assets, and ensuring that the total paid-up capital and share premium do not exceed the prescribed limit. This exemption helps startups raise funds without facing heavy tax burdens.

2. Valuation by Merchant Bankers

Merchant bankers can certify startups’ share valuations, which can help them justify higher prices to investors and avoid tax issues.

However, the process of registration and valuation is often complicated and time-consuming, which adds to the worries of young businesses.

Impact on India’s Startup Ecosystem

India has become the third-largest startup hub in the world. But Angel Tax has been like a speed bump on this fast-moving road.

1. Hurts Ease of Doing Business

The government talks about making India business-friendly, but complicated tax laws like Angel Tax send a mixed message.

2. Pushes Startups Abroad

Many Indian startups prefer to register in other countries like Singapore and the US, where such taxes do not exist. This leads to a loss of innovation and economic growth for India.

3. Impacts Future of AIFs

If you’re wondering, “what are AIFs?” they are Alternative Investment Funds that pool money from various investors to invest in startups, early-stage companies, and other ventures. These funds include venture capital and private equity. 

AIFs play a crucial role in supporting startup growth. However, unfriendly tax policies like the Angel Tax can hurt AIF, too, because they depend on startups to grow and generate profits. When startups struggle due to heavy taxation, AIFs face difficulties in delivering good returns to their investors.

What Needs to Change?

To make India a real hub for startups, here are a few things that can be done:

1. Simplify Tax Rules

The process of getting exemptions from Angel Tax should be easy and fast. Startups should not waste time on paperwork when they should be focusing on building their businesses.

2. Fair Valuation Methods

There should be more flexible ways to calculate share prices, given that startup valuation is not an exact science—it’s about future potential, not just current assets.

3. Encourage Angel Investing

Instead of taxing investors and startups, the government should give incentives like tax breaks to those who invest in startups, similar to what happens in developed countries.

4. Clarity for AIFs

Since AIFs play a big role in funding startups, clear and friendly tax rules for them will ensure better funding opportunities for entrepreneurs.

Conclusion

Angel Tax was introduced to prevent illegal money transactions, but it has unintentionally become a hurdle for genuine startups and investors. Although there have been improvements in recent years, much more must be done to encourage startup growth and angel investing in India.

If you want to start a business or invest in one, staying informed about taxes and getting help from experts, such as share market advisory services, is essential for better planning. You should also always monitor your returns using tools like a CAGR calculator to understand how your investments grow.

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