Angel tax – a new avenue of tax department

In the recent past, many startups have seen the demon of ‘angel tax’ hovering over them with the weapon of huge tax demands.

An idea is born, immeasurable efforts are made, numerous challenges are faced, various doors are knocked, and then a startup is created.

It is acknowledged that a successful idea is worth more than a thousand assets and this is what an investor pays for. Entrepreneurs skirmish to raise funds for turning their idea into reality. Startups are initially promoter-funded; once the idea crystalizes, funds are raised from family and friends in order to reach a stage where they can deliver “Proof of Concept”; i.e. demonstrate that the idea will work. Thereafter, it seeks funding from angel investors or seed investors. Such funds are used for developing a product having sufficient features to run trial tests or acquire initial users, which is commercially known as Minimum Viable Product (MVP). Once the MVP is successfully developed, the startup looks for expansion; in this phase, funds are invested by venture capitalists. The life cycle of a startup is depicted in this chart:

In order to incentivise startups, the government has introduced a beneficial tax rate of 25 percent and a tax holiday period of 3 years for startups who fulfill certain conditions. However, they are not completely immune from all tax provisions. In the recent past, startups have seen the demon of “angel tax” hovering over them with the weapon of huge tax demands.

Investments by angel investors into startups are usually not made based on the traditional methods of valuation (i.e. discounted cash flow method or net asset value method), but on the basis of exit valuation. The valuation of a startup, thus, does not necessarily depend upon financial performance but many other factors such as technology, development, market penetration, etc. Owing to such factors, the value of an idea in the mind of an entrepreneur may be higher to that determined under traditional method.

Such fair market value, though it may seem realistic to an entrepreneur or even the investor, it may seem sky-high to revenue authorities as they still value equity shares of startups by traditional methods.

Time and again, revenue authorities have questioned valuation, and any amount raised in excess of fair market value is brought to tax as “income from other sources”.

The provisions of the income tax act have kept investments made by non-residents in private limited company or by venture capital company/ fund in the venture capital undertaking out of the ambit of angel tax. However, investments made by domestic investors, who form a major chunk of angel funding, are prone to angel tax.

In simple words, angel tax is a levy on the difference between consideration received by a startup from domestic angel investors and the fair market value as per the revenue authorities.

Considering this impediment and to provide some respite to startups, the Central Board of Direct Taxes (CBDT) by issuing a notification on June 14, 2016, made angel tax inapplicable to startups falling in the definition given by Ministry of Commerce and Industry.

Thus it is useful to understand the definition of startup given by Ministry of Commerce and Industry.

Though the intentions of CBDT were clear enough to give relief to startups from the rigorous provisions of angel tax, but what constitutes a startup itself may become a subject matter of litigation as all startups are not covered by the definition given by Ministry of Commerce and Industry.

Thus, it is the need of the hour that CBDT comes up with specific guidelines defining startups for the income-tax purpose.

 (Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)