What is Angel Tax? Is the Government's Greed killing Indian Startups?

Perhaps you've come across the term "angel investors" in business news, seminars, or even in books. However, like many of us, you may have forgotten the details. That's where I come in to guide you through this fantastic, information-packed article. So, let's take a moment to brush up on our understanding of angel investing and dive deep into an essential component - angel tax.

Angel investing and angel investors are truly a godsend for startups. Why do I say that? Well, when someone embarks on the journey of starting a business, the very first and most crucial thing they need is money - or in financial terms, capital. Think of it like a plant on its way to grow big and green. What's the first stage of the plant's journey? It all starts with a seed, right? Similarly, at the nascent stage of a business, that seed financing is essential. 

This is where angel investors come in. They provide the seed financing that startups need to thrive as long as they believe in the idea and want to help it succeed. These angels can be anyone with significant wealth, from your family and childhood friends to people you know in your professional network.

Investing in publicly listed companies is like taking a stroll in the park - it's relatively safe and peaceful. However, when it comes to private companies, it's like going on an adventure in an unknown forest - there are risks and dangers lurking around every corner. While SEBI serves as a protector for retail investors in the former, there is no such safeguard in the latter. And let's face it, investors may also use this lack of oversight to their advantage and get involved in illicit activities.

So, to address this problem, the government, in 2012, introduced the angel tax - a tax levied on angel investors' funding. It's a unique tax that serves as a deterrent against fraudulent activities and ensures that legitimate startups receive funding.

Angel tax refers to a tax imposed on the funding received by startups from angel investors. This tax is based on the difference between the actual value of shares issued and their fair market value.

Angel Tax Applicability

If you thought that all the funds provided by the angel investor to a company are subject to taxation, then there is more to the story. The tax is only levied on the premium amount of the shares bought by the angel investor. Premium is just the difference between market value and face value. Simple as that! But what do these jargons mean? Let’s understand!

Imagine there are two pizza places- Tominoz and PaPinoz Pizza. Tominoz sells each pizza at ₹20, and PaPinoz sells at ₹8. Let's say that the cost of the dough and cheese for a pizza is ₹7 and ₹3, respectively. So the total cost of making a pizza is ₹10. This is the face value of the pizza.

But if you're a hardcore Tominoz fan and you're willing to pay ₹20 for their pizza, then that's the market value of the pizza. The market value is the price that people are willing to pay for a particular product or service, which can be more or less than the face value.

In this case, Tominoz earns a profit of ₹10 per pizza. This ₹10, i.e. the difference between the cost of making the pizza and the price people are willing to pay is the premium.

On the other hand, PaPinoz Pizza sells pizzas at face value, which is ₹10. However, no one wants to buy those pizzas, so they're not able to sell them at the market value. As a result, they sell each pizza at a discounted price of ₹8. That's a loss for PaPinoz, but it's better than not selling the pizzas at all.

Similarly, each share has a face value and a market value, which can be more or less than the face value. Let's break it down with a finance-related example. Imagine a startup receiving an angel fund of ₹1 crore. Out of this, ₹ 80 lakhs is the actual value of the shares and ₹. 20 lakhs is the premium amount paid by the angel investor. In this case, the angel tax will only be levied on the premium amount of ₹ 20 lakhs.

You're probably wondering how much of the company’s hard-earned money is gonna end up in the government's pocket, right? As per Section 56(2)(vii)(b) of the Income Tax Act, 1961, the tax rate is 30% with an additional 3% cess, which results in an effective rate of 30.9%. It's a lot, I know, but it is essential to remember that taxes play a vital role in supporting the development of our nation. Plus, it’s not like these investors are strapped for cash!

Latest Update to Angel Tax according to Budget 2023

The latest update in the Angel tax context is causing quite a stir. With the 2023 budget proposal, the tax that was previously limited to domestic investors will now apply to foreign investors as well!

This move has got everyone feeling a little nervous. However, it signifies the government's intention to ensure transparency and prevent the misuse of funds in startup investments. Predictions are that it could potentially discourage foreign investors, leading to a significant reduction in the number of investments flowing into the startup scene. And let's face it, that's not good news for any of us!

Angel Tax Exemption for Startups

The startup community in India had been advocating for relaxation in the stringent taxation norms that had become a considerable bottleneck in their growth journey. Their wait finally ended in 2019 when the government decided to exempt angel tax on funds for startups. The exemptions had been long-awaited by the startup fraternity.

Can you imagine how thrilled these startups were? But here's the catch - not all startups are eligible to bask in the glory of these coveted exemptions. So, what exactly are the eligibility criteria for these diamond-like exemptions? Well, let's find out! 

1. To be part of the privileged few, a startup must first be recognised by the Department for Promotion of Industry and Internal Trade (DPIIT).
2. The startup must also have a total paid-up share capital and premium that doesn't exceed ₹25 crores.
3. A certified merchant valuer must report the startup's fair market valuation to qualify.

Startups meeting the above criteria can now heave a sigh of relief as they no longer have to worry about the angel tax. This move is expected to encourage investments in startups and help them grow without the fear of excessive taxation. And this will undoubtedly help them unleash their full potential and contribute significantly to the country's economy.

The Bottom Line

In conclusion, angel investors and angel tax are like two sides of a coin. On one side, you have these fabulous people who believe in your startup and provide the necessary seed funding to help it grow. And on the other side, you have the government waiting to take a bite out of that seed funding.

The introduction of exemptions on angel tax is like a breath of fresh air for those who have been struggling to secure funding and grow their businesses! Now, there's still hope for entrepreneurs to keep more of their hard-earned money. Just make sure you meet the eligibility criteria if you wish to taste the slice of cake which is tax exemption. So, keep on hustling, and who knows, maybe one day you'll be the one giving out angel investments and enjoying tax exemptions like a boss!