Angel Tax - Meaning, Applicability and Exemption Rules

As per the Section 56(2)(viib) of the Income Tax Act, 1961 the notification for which was made through the Finance Act, 2012, tax payment is required from the startups in case it receives investment from angel investors and the amount of investment exceeds the Fair Market Value of the company. This is referred to as income from other sources and attracts a tax rate of thirty percent. 9%.

But the Union Budget 2024 unveiled the elimination of the angel tax for the FY 2025-26 to enhance the concept of startups in India.  For instance, in a situation where a startup gets Rs.20 crore from an angel investor; but its FMV of issued shares is Rs.15 crore; then the remaining Rs.5 crore is taxed. The tax had been introduced to control such money and make them compliant as the new business entities did not have clean accounts, thereby causing a generation of black money. This enticed the Income Tax department to tax share premiums in excess of FMV.

What are the drawbacks of Angel Tax?

Here are some significant drawbacks of the angel tax:

1. It relates to the startup funded by the resident Indian investor.

1. Start up firms which received investments from venture capitalists and non-resident investors cannot claim angel tax deductions.

1. The target company loses significant funds to taxes as angel tax requires the sharing of most of the investment.

Exemption on Angel Tax

The innovative firms are at a loss because of angel taxes since it reduces their investment, thus a key worry for new firms. This tax was specifically disliked when it was first implemented as the investors and entrepreneurs of the economies had a lot of worry regarding this tax. Thus, in the Union budget of 2019, there was a concept of Exemption introduced which has provided exemptions for such startups, which have been registered under DPIIT. However, to avail this, the startups were made to file an application to the Central Board of Direct Taxes (CBDT).  In this regard, it means that startups need to meet some conditions: paid up capital and share premium does not exceed Rs.25 crore; and for the turnover of the startup cannot exceed Rs.100 crore for any fiscal period. In addition to that, the amount is deductible in full provided that the angel investor meets the residences, gross income, and net worth tests.

The angel tax has been completely abolished from all classes of investors from the financial year 2025-26 for development of the startup culture, the finance minister Nirmala Sitharaman announced during the recently concluded Union Budget.

Angel Tax Rate in India

India therefore employs the ratio as well as the progressive structures of taxation that are given based on income and other aspects. In this regard, the angel tax remains virtually unmanageable for budding businesses. It earlier stood at 30%, and there was no further deduction. And if its excess capital investments exceeded that amount, then a marginal rate of 9% was applicable on every share of investment that is over the FMV. Every fund raised from investors was taxable and was compulsory for new businesses subject to the rules by the Income Tax Department.

Example to understand how Angel Tax worked

Angel tax has posed significant challenges for startups, as it eats into a substantial portion of their investment. Here's an example for clarity:

Imagine your startup secures an investment of Rs 50 crore by issuing 1 lakh shares to an Indian investor at Rs 5000 each. The fair market value (FMV) per share is Rs 2000, totaling Rs 20 crore. The excess investment above the FMV is Rs 30 crore (Rs 50 crore - Rs 20 crore). Consequently, the angel tax applies to this excess, amounting to Rs 9.27 crore (30.9% of Rs 30 crore). 

Conclusion

Despite exemptions for startups and investors, angel tax faced significant backlash, impeding the growth of numerous startups in India. Its imposition complicated the funding process, deterring investors and stifling innovation. Consequently, the abolition of angel tax is hailed as a major reform, expected to streamline funding procedures and bolster the country's startup ecosystem. This change aims to foster a more supportive environment for startups, encouraging investment and growth in the entrepreneurial sector.