What is Angel Tax?

• Angel Tax is the income tax levied on the capital raised by unlisted companies (typically startups) when they issue shares to investors at a price higher than the Fair Market Value (FMV) of the shares. 
• The excess amount received over FMV is taxed as “income from other sources” under the Indian Income Tax Act.
  • Legal Provision: Section 56(2)(vii b) of the Income Tax Act, 1961
  • Applicable To: Unlisted, private companies issuing shares to residents or non-residents at a premium exceeding FMV.

Why Was Angel Tax Introduced?

• The tax was introduced in 2012 to address two key concerns:
  • Curbing Money Laundering: Authorities suspected that shell companies were receiving investments at inflated valuations to route black money.
  • Preventing Tax Evasion: Investors could use overvalued equity investments to avoid paying appropriate income taxes.
• Thus, Angel Tax was intended as a deterrent against the misuse of the startup ecosystem for illegitimate financial activities.

Who Are Angel Investors?

• Angel investors are usually wealthy individuals who provide early-stage capital to startups, often before they are eligible for venture capital funding.
• They:
  • Invest based on vision and potential, not just current revenue or assets.
  • Take high risks in exchange for equity ownership and future returns.
  • Often act as mentors and bring domain expertise and networks.

How Angel Tax Works – A Simplified Example

• If a startup's FMV is ₹100 per share, but it issues shares to an investor at ₹150, the ₹50 premium per share is considered excess and treated as income under Section 56(2)(vii b), and taxed accordingly.

Expansion of Angel Tax Scope (Post 2023)

• Earlier, Angel Tax was applicable only to Indian residents. However, as per the Union Budget 2023–24, the scope of Angel Tax was expanded to include foreign investors (non-residents), subject to certain exemptions.

Concerns Raised by Industry:

• Global VC and angel funds may be discouraged due to valuation scrutiny.
• Risk of double taxation if similar gains are taxed in both India and investor's home country.
• Fear of funding slowdown, especially for early-stage startups.

Exemptions from Angel Tax

• The government has taken several corrective measures to ease the burden on startups:

DPIIT Exemption for Recognized Startups

Startups certified by Department for Promotion of Industry and Internal Trade (DPIIT) are exempt from Angel Tax if they meet these conditions:

Exemption for Select Foreign Investors

• India notified a list of 21 countries (e.g. USA, UK, Germany, France, Singapore, etc.) whose non-resident investors are exempt from Angel Tax, based on tax cooperation and FATF (Financial Action Task Force) compliance.

Startup Valuation and Angel Tax

Valuation Methods Permitted by CBDT:

• Startups can justify share valuations using:
  • Discounted Cash Flow (DCF): Projects future cash flows and discounts them to present value.
  • Net Asset Value (NAV): Based on the net worth of company assets minus liabilities.
• Valuations must be certified by a SEBI-registered merchant banker or chartered accountant.

Impact on Startup Ecosystem

Negative Impacts

• Discouraged angel investing due to fear of tax scrutiny.
• Disruption in fundraising cycles and confidence, especially for early-stage ventures.
• Valuation disputes between startups and tax authorities.
• Increased litigation and tax notices to small startups.

Recent Positive Developments

• Policy clarifications and exemptions have helped reduce uncertainty.
• Angel tax reform is becoming central to startup-friendly tax reforms in India.
• Increased reverse flipping as startups find India more conducive post-reform.

Reverse Flipping

• It refers to Indian startups, previously domiciled abroad (e.g., in Singapore, Delaware, etc.) shifting their parent company or holding structure back to India.
• Angel tax reform is seen as a key enabler for this trend.
  • Examples: PhonePe, Groww, and other high-growth startups are moving back to India.

Benefits of Reverse Flipping:

• Retains value creation within India.
• Strengthens domestic capital markets.
• Simplifies regulatory compliance and tax structures.