Why in news?

Indian Inc is urging the removal of the Angel Tax amid a sharp decline in startup funding and job losses.

The Confederation of Indian Industry (CII) recommended scrapping Section 56(2)(viib) of the Income-tax Act, known as the 'Angel Tax,' in its Union Budget suggestions. They argue that removing this tax would significantly help in capital formation in the country.

What’s in today’s article?

• Angel Tax
• Concerns raised by industries

Angel Tax

• Angel Tax is a term basically used to refer to the income tax payable on the capital raised by unlisted companies via the issue of shares through off-market transactions.
• This tax is levied on the capital raised via the issue of shares by unlisted companies from an Indian investor if the share price of issued shares is seen in excess of the fair market value of the company.
• The excess realization is considered as income and therefore, taxed accordingly.
  • E.g., If the fair market value of a start-up share is Rs 10 apiece, and in a subsequent funding round they offer it to an investor for Rs 20, then the difference of Rs 10 would be taxed as income.
• Angel tax gets its name from the wealthy individuals (“angels”) who invest heavily in risky, unproven business ventures and start-ups, in the initial stages when they are yet to be recognised widely.

Rationale behind the introduction of Angel Tax

• Rule related to Angel Tax is described in Section 56(2)(viib) of the Income Tax Act, 1961.
• This clause was inserted into the act in 2012 to prevent laundering of black money, roundtripping via investments with a large premium into unlisted companies.

Budget 2023-24 and Angel Tax

• Investments that used to fall under the ambit of Angel Tax before the introduction of Budget 2023-24
  • Before budget 2023-24, angel tax was imposed only on investments made by a resident investor.
  • i.e., it was not applicable in case the investments are made by any non-resident or venture capital funds.
  • Allaying the concerns of the startup community, the govt had also exempted investments made by the domestic investors in companies approved by an inter-ministerial panel from Angel Tax.
    • i.e., Government recognised startups, upon meeting certain criteria, were exempted from this tax.
• Changes introduced in Budget 2023-24 with respect to angel tax
• The Finance Bill, 2023 has proposed to amend Section 56(2) VII B of the Income Tax Act.
• With this, the government has proposed to include foreign investors in the ambit.
• That means when a start-up raises funding from a foreign investor, that too will now be counted as income and be taxable.
• However, these foreign investors will not need to pay any angel tax while investing in a government-recognised startup in India — similar to the provision for domestic investors.
• Either of domestic or overseas investors investing in a DPIIT-registered startup will not attract the so-called angel tax.
• Rate of tax
  • Currently, angel tax is levied at the rate of 30.6 per cent.

Recent developments regarding the angel tax

• Exemptions given to investors from 21 countries
  • In May 2023, the Finance Ministry had exempted investors from 21 countries including the US, UK and France from the levy of angel tax for non-resident investment in unlisted Indian start-ups.
  • However, the list excluded investment from countries like Singapore, Netherlands and Mauritius.
• Final valuation rules for foreign and domestic investors
  • In September 2023, the Finance Ministry notified final valuation rules for foreign and domestic investors into unlisted companies such as start-ups under the new angel tax mechanism.
  • The rules had accounted for the industry’s calls by addressing an additional sub-clause of compulsorily convertible preference shares (CCPS).
    • CCPS are a type of preferred stock that can be converted into a fixed number of equity shares of the issuing company after a specified date.
  • It stated that the valuation of CCPS can also be based on the fair market value of unquoted equity shares.
• Clarification issued by CBDT
  • In October 2023, CBDT asked its field officials to not do verification for the recognised start-ups for cases pertaining to Section 56 (2) (viib) of the Income-tax Act.
    • There are 99,380 startups recognised by the DPIIT.
  • Besides, in cases where proceedings are auto generated, contentions of such recognised startup companies on the issues will be summarily accepted.
  • This clarification by the tax department comes after many startups had raised concerns about receiving scrutiny notices for angel tax.
    • Many startups received notices under Section 56(2)(viib).
    • They were asked to furnish income tax returns (ITRs) of their stakeholders for the past three consecutive years.

Concerns raised by industries

• The industry has argued that the government is wrong in citing the difference between valuations and actual performance as a sign of money laundering.
• They further added that investors fund startup based on their future potential. Taxes levied on the difference between issue price of unlisted securities and its fair market value (FMV) has hurt funding.
• The changes in the Angel Tax provisions came at a time when an estimated 100 Indian startups laid off over 15,000 employees in 2023, as funding winter that began in 2022 persisted.
• Indian startups witnessed over 60 per cent decline in funding in terms of value in 2023.