On July 23, Finance Minister Nirmala Sitharaman announced the abolition of the “angel tax” in the Budget 2024, bringing significant relief to startups and their investors. Here’s a look at the history of the angel tax and its implications for the startup ecosystem.
What is Angel Tax?
Angel Tax, formally known as Section 56 (2) (viib) of the Income Tax Act, was a tax imposed on funds raised by startups from angel investors that exceeded the fair market value of the company. For instance, if a startup with a fair market value of Rs 1 crore raised Rs 1.5 crore from angel investors, the excess Rs 50 lakh was subject to tax. The tax rate was around 31 percent, as tax authorities considered the premium paid by investors as income.
Origins of the Angel Tax
The angel tax was introduced in the 2012 Union Budget by then Finance Minister Pranab Mukherjee. The main aim was to prevent money laundering through investments in startups and to catch bogus firms.
Issues Faced by Startups
Many startups found the angel tax excessively burdensome and unfair. They argued that assessing the fair market value of a startup was impractical, with Assessing Officers often using the discounted cash flow method, which seemed to favor tax authorities. Startups reported receiving tax notices for investments raised 3-4 years earlier, with some tax and late payment fees exceeding the original funding amount. In 2019, a survey by LocalCircles showed that over 73 percent of startups raising capital between Rs 50 lakh to Rs 2 crore received angel tax notices.
Impact on Domestic and Foreign Investors
Initially, the angel tax applied only to investments made by resident investors but was later extended to foreign investments. Although the 2019 Union Budget provided some relief by exempting Department for Promotion of Industry and Internal Trade (DPIIT)-registered startups, it wasn’t a blanket exemption. Only startups certified by the Inter-Ministerial Board (IMB), a group of bureaucrats assessing innovation, qualified for the exemption. Out of 84,000 DPIIT-registered startups, less than 1 percent were IMB-certified.
The removal of the angel tax is expected to foster a more supportive environment for startups, encouraging investment and innovation without the looming threat of unfair tax burdens. This change reflects a significant step towards making India a more attractive destination for both domestic and international investors.
