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Senior Associate, Direct Tax
Angel taxation, a provision under Section 56(2)(viib) of the Income Tax Act, 1961, has long been a contentious issue for startups and angel investors in India. It aimed to curb the misuse of share premiums by closely held companies to evade taxes. However, this provision had unintended consequences, stifling investment in early-stage businesses and hindering the growth of the startup ecosystem. Recognizing these challenges, the Indian government introduced significant amendments to angel taxation to create a more startup-friendly environment. In this article, we will explore the key amendments made to the angel taxation provisions and their implications for startups and angel investors.
In 2023, the Indian government took a significant step towards fostering a conducive environment for startups and angel investors by introducing crucial amendments to the Angel Taxation provisions under Section 56(2)(viib) of the Income Tax Act, 1961. The changes aimed to address the challenges faced by startups in raising capital and reducing the burden of compliance, encouraging more investments in early-stage ventures. In this article, we will explore the key amendments made in 2023 to Angel Taxation and their potential impact on the startup ecosystem in India.
Memorandum to Finance Act 2023 states that Section 56(2)(viib) of the Income Tax Act 1961 (‘the Act’) was inserted by Finance Act, 2012, to prevent the generation and circulation of unaccounted money through share premium received from resident investors. The 2023 amendment, however, included the consideration received from a non-resident also under the ambit of Section 56(2)(viib) by removing the phrase ‘being a resident’ from the said clause.
The amendment reiterated the original objective of expanding the scope of Section 56(2)(viib) without providing a rationale for the same. The modus operandi exercised by tax authorities in enforcing this provision renders the original objective peripheral and irrelevant. Investors have been receiving notices from the department examining their creditworthiness, despite the fact that the source of funds was never in doubt. The manner in which Section 56(2)(viib) is being applied is without any regard to its original intention, i.e., preventing the circulation of black money.
The term ‘angel tax’ now seems like a contradiction by and of itself, as we discuss angels on the one hand and tax them on the other. In order to analyse the ramifications of the new provisions, let us briefly look at the changes introduced in the Finance Act 2023 and subsequent notifications vis-à-vis the erstwhile provisions.
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Pre – Amendment |
Post – Amendment |
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Only ‘resident’ investors were covered |
Both ‘resident’ and ‘non-resident’ investors were covered |
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Rule 11UA: Only two methods 1. DCF (Discounted Cash Flow) 2. NAV (Net Asset Value) method |
Five additional valuation methods are provided under Draft Rule 11UA for non-residents aligning with FEMA 1. Comparable Company, Multiple Methods 2. Probability-Weighted Expected Return Method 3. Option Pricing Method 4. Milestone Analysis Method 5. Replacement Cost Methods |
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Exclusions: DPIIT-registered start-ups (meeting specified conditions) The amount of paid-up capital does not include funds from non-residents and venture capital funds |
Exemption from Angel Tax is extended to ‘notified entities’ from ‘Specified Nations’ |
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Price Matching Method is not available |
Price Matching for both resident and non-resident investors |
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Safe Harbour is not available |
Safe Harbour for both resident and non-resident investors |
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A contemporaneous valuation report is required, but no time period for validity is specified |
90 days are specified as the time period for the validity of the valuation report (at the option of the assessee) |
As the amendment is proposed to be effective on April 1, 2023, it would be worthwhile to see if companies in the interim accelerate their investment plans, which would increase foreign investments.
The valuation adopted by the companies will be under closer scrutiny from the tax authorities. Various deals and negotiations that take place on business structuring may vex non-resident investors and have an impact on the deal’s value. The Indian company or promoter group may also be impacted, as in the new era of dynamic business, the valuation determined based on one of the methods (i.e., net asset value or discounted cash flow) could be very subjective. At times, the actual value would be way different from the valuation reports. In the new era, companies and founders used to take advantage of this uncertainty by using a higher value while taking investments from non-residents and, in turn, offering less equity. The proposed amendment takes away this arbitrage, and the companies or founders need to dilute more or agree to pay taxes.
The amendments made to the Angel Taxation provisions under the Income Tax Act, 1961, in 2023 mark a significant milestone in India’s journey to create a vibrant and thriving startup ecosystem. The removal of the Angel Tax for DPIIT-recognised startups, the increased investment limit, and expanded accredited investor norms are bold steps towards encouraging innovation and entrepreneurship. These changes are expected to boost startup funding, attract global investments, and position India as a hotspot for innovation in the years to come. As the startup ecosystem continues to evolve, it is imperative for the government to stay engaged with stakeholders and consider further refinements to support the growth and success of startups in India.
