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On July 23, 2024, the Finance Minister Nirmala Sitharaman through the introduction of the Finance Bill, 2024,[1] held that Section 56(2)(viib) of the Income Tax Act, 1961 (“Act”), shall be inapplicable from April 01, 2025, thereby abolishing the angel tax from the Financial Year 2024-25. Angel tax had been a source of distress for startups looking to raise funds and its abolition has brought a sense of relief amongst many startups that have been at the receiving end of tax notices for having raised funds allegedly at a price over their fair market value. Aimed at preventing generation and circulation of unaccounted money in India, angel tax had been levied on unlisted companies to tax funds raised by such companies via issuance of shares at a value over and above its fair market value. Angel tax was levied under the head ‘Income from Other Sources’ of the Act.
It has long been argued that in startups, it may not be possible to determine the fair market value of shares due to the inherent uncertainties about the future business prospects of the company. The investors, with their experience and understanding of the company’s potential, are often the best judges of its value. They may invest at a premium based on anticipated future growth, innovation or strategic advantages that are not immediately quantifiable. This premium reflects the investor’s confidence in the company’s future performance rather than its current financial metrics.
Timeline of Angel Tax:
Angel tax was introduced by the Finance Act, 2012, by the then Finance Minister Pranab Mukherjee. At the time when the angel tax was introduced, it was levied on the consideration received in excess of the fair market value of shares from the Indian residents. However, through the Finance Act, 2023, it was extended to apply to the consideration received in excess of the fair market value of shares from any person, whether resident or non-resident.
Central Board of Direct Taxes (“CBDT”) vide notification dated July 12, 2017,[2] amended Rule 11UA of the Income tax Rules, 1962, amending the formula for determining the fair market value of unquoted shares. Subsequently, CBDT vide notification dated September 25, 2023,[3] introduced several formulae that unlisted companies can use to determine the fair market value of their unquoted equity shares, such as Net Asset Value and Discounted Free Cash Flow. Unlisted companies are free to choose any of the provided methods. However, in cases where the funds are received from a resident, the following methods are not available for selection: (i) Comparable Company Multiple Method; (ii) Probability Weighted Expected Return Method; (iii) Option Pricing Method; (iv) Milestone Analysis Method; and (v) Replacement Cost Methods. Rule 11UA also provided for manner of determination of fair market value of compulsorily convertible preference shares.
Proviso (ii) to Section 56(2)(viib) of the Act provides that angel tax shall not be levied on a company that receives consideration for issue of shares from a class or classes of persons as may be notified by the Central Government. In exercise of its powers, several notifications were issued by the Department of Promotion of Industry and Internal Trade (“DPIIT”) and CBDT.
DPIIT was established under the Ministry of Commerce and Industry in the year 1995, to develop and execute strategies aimed at fostering the growth of the industrial sector. DPIIT vide notification dated April 11, 2018,[4] exempted startups being private limited companies recognized by it from the applicability of Section 56(2)(viib) of the Act, subject to such companies meeting conditions laid down under the said notification. DPIIT then vide notification dated February 19, 2019,[5] amended the conditions to: (i) increased the time period for recognition as a startup from 7 years to 10 years, from the date of its incorporation; and (ii) increased the cap on turnover for any financial year since its incorporation from Rupees 25 crore to Rupees 100 crore. As on June 30, 2024, DPIIT has recognized 140,803 startups, which have been reported to have generated over 1.553 million direct jobs.[6]
CBDT, as a statutory body, is entrusted with the administration of the Income Tax Act. CBDT had vide notification dated May 24, 2023,[7] exempted certain foreign entities residing in 21 specified countries or territories, including United States, United Kingdom, Japan, Australia and others, from the provisions of Section 56(2)(viib) of the Act. Such entities must be regulated in their country of establishment, incorporation or residence. The exempted entities include: (i) SEBI-registered Category-I Foreign Portfolio Investors; (ii) endowment funds associated with a university, hospitals or charities; (iii) pension funds established under foreign law; and (iv) broad-based pooled investment vehicles with over 50 investors, excluding hedge funds or those employing diverse or complex trading strategies.
Finally, Section 56(2)(viib) of the Act was abolished through the Finance Act, 2024.
Criticism of Angel Tax:
Angel tax was criticized on several grounds, such as: (i) lack of clarity on the valuation of fair market value of shares; (ii) increased disputes due to non-satisfaction of the assessing officers with the valuation adopted by a company; and (iii) higher rate of tax on the premium amount, leading to availability of less fund with the companies to meet its business purpose. Moreover, given the resistance to the angel tax, the Government had to keep amending the provision as well as the rules to grant exemptions to certain recognized startups and specified entities.
Conclusion:
Angel tax was in force in India for 12 years and rather than effectively serving its purpose, it acted as a hindrance for companies in India that were raising funds through issuance of shares. The Government tried to minimize the adverse effects of the angel tax through various relaxations, yet that left many legitimate businesses still in the lurch. With the introduction of many other laws that are more effective at curbing corruption, the Government rightfully realized that angel tax was a needless intrusion into the legitimate business affairs of a commercial enterprise. Abolition of the angel tax should aid the ease of doing business and strengthen India’s startup ecosystem.
Footnotes
[1] Finance Bill, 2024- https://www.indiabudget.gov.in/doc/Finance_Bill.pdf
[2]Gazette Notification no. G.S.R. 865(E), issued by CBDT on July 12, 2017.
[3] Gazette Notification no. G.S.R. 685(E), issued by CBDT on September 25, 2023.
[4] Gazette Notification no. G.S.R. 364(E), issued by DPIIT on April 11, 2018.
[5] Gazette Notification no. G.S.R. 127(E), issued by DPIIT on February 19, 2019.
[6] Question no. 2490: Questions and Answers at the Lok Sabha session 2 on August 6, 2024- https://sansad.in/ls/questions/questions-and-answers
[7] Gazette Notification no. S.O. 2274(E), issued by CBDT on May 24, 2023