Angel Tax: A Closer Look Into How It Impacts Start-up And Investors

Unlisted companies or start-ups offer equity in exchange for investments. These investments are often seen by the government as 'income', when they exceed the Fair Market Value of the shares.

Currently, angel tax is levied at a hefty 30.6 per cent on investments over and above the fair market value. 

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Start-ups often keep raising concerns about the 'angel tax' and it's impact on investors. While the term might sound interesting, it is important to understand what it completely entails. Will it impact you if you wish to invest in start-ups? Let's take a deeper look.

Every unlisted company (a start-up or otherwise) needs to raise funds and one of the ways to attract investors is to offer equity in exchange for investment. While this can be seen as funding, the government sees this money as ‘income from other sources’. 

When the capital raised by unlisted companies through share issuance exceeds the ‘fair market value’ (FMV) of the shares, the government levies income tax on this capital known as ‘Angel Tax’. The excess investment, by domestic and foreign investors, is considered as ‘income from other sources’ and the government levies ‘Angel Tax’ on it, since it primarily affects angel investors in start-ups. 

This tax is imposed under Section 56(2) (viib) of the Income Tax Act, 1961. The Angel Tax was introduced in this section as part of the Finance Act, 2012. However, the government earlier didn’t include non-resident investors under the ambit of this tax. Changes introduced in The Finance Act, 2023 stated that both domestic and foreign investors will be obligated to pay ‘Angel Tax’, if their investment exceeds the FMV. 

Tax Rate

Currently, angel tax is levied at a hefty 30.6 per cent on investments over and above the fair market value. 

Eligibility And Exemptions

Prior to April 1, 2023, this tax was levied on investments made into unlisted firms by domestic investors. However, recent changes introduced earlier this year have brought investments from foreign investors under the ambit of this tax. Some norms and valuation rules differences remain for domestic and foreign investors. 

According to the new laws, every foreign investment will not be subjected to angel tax. The exemptions have been provided to three classes of foreign investors, including government-related investors, like central banks, sovereign wealth funds, and global or multilateral organisations; banks or organisations in the insurance business; and investors from three categories, and residents of specified countries, namely the SEBI Registered Category-I FPIs, specific categories of endowment and pension funds, and broad-based pooled funds with 50 or more investors that are not a hedge fund or a fund that employs complex trading strategies. The exempted countries are Australia, Germany, Japan, Korea, the UK, and the US among others. 

For companies, the exemptions remain the same. A company is eligibile for exemption from the 'Angel Tax' if it has been recognised by DPIIT under para 2(iii)(a), or if the aggregate amount of paid up share capital and share premium of the firm after issue or proposed issue of share doesn't exceed Rs 25 crore. This basically means that small-scale angel investors who invest under Rs 25 crore are exempted from this tax.

Valuation

Now, the next question arises how is this tax calculated?  According to the changes made under The Finance Act, of 2023, some methods for the valuation of shares have been added after discussions with stakeholders. Along with the earlier two methods, the Discounted Cash Flow (DCF) and the Net Asset Value (NAV) method, the companies will now have the option of five more methods available for foreign investors to calculate the share value. These methods are, the Comparable Company Multiple Method, Probability Weighted Expected Return Method, Option Pricing Method, Milestone Analysis Method, and Replacement Cost Method. These new methods have been introduced to facilitate foreign investors and encourage them to invest in Indian companies. 

Similarly, the new rules allow price matching for domestic and foreign investors with reference to investment by venture capital funds or specified funds. The valuation methods for determining the fair market value of compulsorily convertible preference shares (CCPS) has also been provided for the investors. Additionally, a safe harbour of 10 per cent variation in FMV of shares has been permitted by the government.