Angel Tax Exemption For Startups

Angel Tax! What’s the hype about?

This week, the government relaxed a few rules for startups raising equity funding from Angel Investors.

What Is Angel Investment And Angel Tax?

Angel investments made by angel investors are the earliest equity investments in startup companies seeking capital for the growth of their businesses and, these investments may either be a one-time investment or regular investments. Angel investors may be individuals or corporations or a consortium of angel investors coming together with the basic aim of helping entrepreneurs grow and develop their business. In exchange for their financial contributions, they seek convertible debt or ownership equity in the startup.

Angel Tax refers to the income tax payable on capital raised by unlisted companies where the share price is in excess of the fair market value of the shares sold when startups are valued based on their innovative business model at higher than market values. Thus, the excess realization is treated as income and taxed accordingly. For example, the price of a share is Rs. 10/- but the amount obtained for that share from the angel investors is Rs. 100/-. This excess amount of Rs. 90/- will then be taxable in the hands of the startup company as per Section 56 (2) (vii-b) of the Income Tax Act, 1961.

Problems Faced By Startups Due To Angel Tax?

The following were the common problems that were faced by startups due to angel tax:

  • Valuations for raising capital:

    The shares had to be valued to decide whether the amount received or to be received from an investor was in excess of the fair value on the basis of the discounted cash flow method (DCF), which is a highly subjective issue as it is a function of the company’s projected earnings at that point in time and 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.

  • Notice from Income Tax Department:

     Many startups during the last couple of years have received notices from the Income Tax Department asking them to explain their valuations and to pay as much as 30% of their funding as a tax. There is also an added legal cost which they need to bear to get a certified valuation report from valuers coupled with the compliance burden of responding to notices and attending hearings.

However, on 19th February 2019, The Ministry of Commerce (Department of Promotion of Industry and Internal Trade) vide Notification No G.S.R 127(E) has modified the definition of Startup’s and eased the process for obtaining Angel Tax Exemption for “Eligible Startups”. The following are the highlights of this notification which is a boon to the startups:

Who Is An “Eligible Startup”?

A startup is an “Eligible Startup” if set up as a Private Limited Company or a Limited Liability Partnership (LLP) or Registered Partnership Firm and fulfills the below criteria:-

  • Not older than 10 years from the date of incorporation/registration.
  • Annual turnover not exceeding INR 100 crore in any preceding financial years since incorporation.
  • Working towards innovation, development or improvement of products or processes or services. OR If it is a scalable business model with a high potential for employment generation or wealth creation.

Due to the above notification with relaxed norms on revenue, many more startups have come under the purview of the definition of eligible startups

Angel Tax Exemption For Startups 56 (2)(viib) Of Income Tax Act

A Startup shall be eligible to claim Angel Tax Exemption For Startups under Section 56(2)(viib) if it fulfills the following criteria:-

The aggregate paid-up capital and share premium of the eligible start-up post issue of shares in not more than 25 crores.

This means that startups can raise equity from angel investors without any tax implications or scrutiny’s or certified valuations up to Rs 25 Cr. Another thing to note here is that for the purposes of calculation of INR 25 Crores limit for the above aggregate amount of paid-up Capital and Share Premium, any consideration received in respect of a share issued from following persons shall not be included :

  • Non-resident
  • Venture Capital Company or Venture Capital Fund
  • Listed Companies whose shares are frequently traded and whose Net Worth as on the last date of financial year exceeds 100 crores or Turnover for previous Financial Year exceeds 250 Crore.

The caveat to the above exemption is that the startup should not invest in the below-specified category of assets for a period of seven years from the date of issue of its shares:-

  • building or land thereto, whether a residential house or not.
  • loans and advances to others other than in the ordinary course of business.
  • a capital contribution made to any other entity other than in the ordinary course of business.
  • shares and securities.
  • motor vehicle, aircraft, yacht or any other mode of transport exceeding INR 10 lakhs and jewelry or any forms of art.

Non- compliance of the above will lead to the exemption that has been availed to be withdrawn.

In our opinion the above changes are a great boost, not only for startups looking to raise finances but also for those willing to invest in startups as the above notification has signaled the intention of the Government to give certain leeway without interjecting and interfering in the funding processes of the startups on the realization that they are the future employment generators and leaders of economic growth.

If you need any more clarification on the above norms or are looking out to raise funding for your startup, do not hesitate to contact us at Savage & Palmer.

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