A lot of voices have been raised against an Income Tax Act amendment, which came to be popularly known as the "angel tax". The Department of Industrial Policy and Promotion (DIPP) issued a notification on April 11, 2018 setting out a framework for start-ups to claim exemption from angel tax (Exemption Notification). The 2012 Union Budget introduced a rule that when an Indian private company receives equity investments from an Indian investor at a premium to the company's fair value, the premium is taxed as 'income from other sources'. Angel tax was the result of this rule. This rule was introduced to check illegal money flows disguised as capital investments into nondescript private companies. However, the activity that was affected the most by this rule was angel investments into Indian start-ups by domestic angel investors. It is ironic that the introduction of angel tax coincided with large scale systematic efforts to broad base angel investing. It is also relevant that since the premium to the fair value of the shares is treated as income from other sources the start-up would not be able to adjust the tax against its business losses.
Under the Exemption Notification, if the following criteria are fulfilled in a proposed angel investment, the relevant start-up may apply for an 'approval' for exemption from angel tax:
a. The start-up (other than a biotechnology start-up) is a private limited company incorporated not more than seven years back (biotechnology sector start-ups should have been incorporated not more than ten years back).
b. The start-up is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.
c. The annual turnover of the start-up in any financial year (prior to seeking the approval for exemption) has not exceeded Rs. 25 crores.
d. The total paid up share capital and premium after the proposed angel investment does not exceed Ten Crore Rupees.
e. The investor has an average 'returned income' of twenty five lakh rupees or more for the preceding three financial years, or has a net worth of two crore rupees or more as on the close of the previous financial year.
f. A merchant banker has issued a report to the start-up specifying the fair market value of the shares of the start-up.
In a proposed angel investment where the above criteria are satisfied, the start-up may make an application, prior to the investment, to the eight member Inter-Ministerial Board seeking tax exemption. The Inter-Ministerial Board is comprised of the Additional Secretary of the Department of Industrial Policy and Promotion, and representatives of the Ministry of Corporate Affairs, Ministry of Electronics and Information Technology, Department of Biotechnology, Department of Science & Technology, Central Board of Direct Taxes, Reserve Bank of India, and the Securities and Exchange Board of India.
The framework under the Exemption Notification has a couple of significant structural challenges which potentially make it a non-starter. To set the context, a conservative estimate is that about 400 angel investments were made in the financial year 2017-2018. Looking at the current Indian start-up funding climate, it is safe to say that the current year would see at least the same number of angel investments (the widely held belief is that angel investment activity would grow appreciably this year). Also, typically early stage start-ups (in which angel investments are made) have a very short capital 'runway' and would be dependent on angel investment capital for continuing their operations. Given this, angel investment transactions are executed at a quick pace.
Under the Exemption Notification a start-up receiving angel investment has to make a prior application for exemption from angel tax. The application should include details such as the proposed date of issue of shares to the angel investor(s), number of shares to be issued, price of the shares, etc. Thus, the hundreds of start-ups that receive angel investments would have to apply to the Inter-Ministerial Board once the investment decision has been made and deal terms have been finally agreed upon, but before the actual investment. This requirement of prior approval for tax exemption guarantees delays in the completing an investment, potentially defeating the purpose of the investment. The Inter-Ministerial Board which was originally set up under the start-up India initiative meets once a month. This means two things: (a) start-ups might have to wait for days or weeks before their application is taken up; and (b) every time the Inter-Ministerial Board convenes there would be a significant number of applications which would need to be disposed of, and multiple deferrals of applications appear inevitable. Where the speed of completing the investment is critical, the mechanism proposed under the Exemption Notification unfortunately fails to deliver the intended objective.
It now seems clear that the start-up ecosystem needs to engage further with the government to try and hammer out a workable solution to the angel tax issue.
Originally published on 16 May 2018
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