What is Angel Tax?
The angel tax, introduced by Section 56(2)(viib) of the Income Tax Act, 1961, applies to unlisted companies (startups whose shares are not publicly traded) that receive funding exceeding the Fair Market Value (FMV) determined by the government. This excess investment is considered “income from other sources” and is taxed at a rate of 30.9% (inclusive of a 30% income tax rate and 3% cess). Section 56(2)(viib) of the Income Tax Act 1961 encompasses a provision that pertains to closely-held companies issuing shares to resident investors at a value exceeding the “fair market value” of those shares. In such cases, the surplus amount of the issue price over the fair value is subject to taxation as the income of the company issuing the shares. Hence, angel tax is a built-up concept inculcated in the Finance Act, 2012 over the foundational block of provisions of the Income Tax Act, 1961.
The core issue lies in determining a startup’s FMV. Unlike established companies with a track record, startups are young and often lack a readily available market value. This makes the government’s FMV assessment subjective and potentially inaccurate. Imagine a scenario where an investor believes your innovative idea has immense potential and offers Rs 15 crore for shares whose FMV is estimated at Rs 10 crore by the government. Under the angel tax, that Rs 5 crore difference would be taxed, creating a significant financial burden on an early-stage company.
Which Investment Falls Under the Angel Tax Category?
Any funding a startup receives from an investor, if it exceeds the FMV determined by the government, falls under the angel tax category. This can include investments from angel investors, individuals who provide early-stage capital, or even venture capitalists if the startup is still unlisted. The key factor is the difference between the investment amount and the government’s FMV assessment, not the specific type of investor.
What is an Angel Tax Exemption?
The Indian government has introduced exemptions to the angel tax. The new policy exempts startups registered under the Department for Promotion of Industry and Internal Trade (DPIIT) from the angel tax.
The primary route to tax benefits lies in obtaining recognition from the Department for Promotion of Industry and Internal Trade (DPIIT). This involves submitting an application along with supporting documents to the Central Board of Direct Taxes (CBDT). Once approved, your startup can breathe a sigh of relief and be shielded from the angel tax.
Eligibility Criteria for Angel Tax Exemption
In order to get an exemption, the government has laid down eligibility criteria for angel tax exemption in a two-fold structure. A startup has to be first recognized and registered as prescribed under G.S.R. notification 127 (E) are eligible to apply for recognition under the program. The two-fold structure includes:
- Eligibility Criteria for Startup Recognition
- Eligibility Criteria for Tax Exemption under Section 56 of the Income Tax Act, 1961
Eligibility Criteria for Startup Recognition (DPIIT)
While DPIIT (Department for Promotion of Industry and Internal Trade) recognition for a startup unlocks the exemption door, there are specific criteria a startup needs to fulfill:
The company must be incorporated as a private limited company or registered as a partnership firm or a limited liability partnership.
The company’s turnover should not exceed INR 100 Crore in any of the previous financial years.
A company shall be considered as a startup up to 10 years from the date of its incorporation.
The company should demonstrate a focus on innovation or improvement of existing products, services, or processes. Additionally, it should have the potential for job creation or wealth generation.
Companies formed by splitting up or restructuring an existing business are not eligible for this recognition.
Eligibility Criteria for Tax Exemption under Section 56 of the Income Tax Act, 1961
After getting recognition, a startup may apply for an angel tax exemption. The eligibility criteria are as follows:
The startup must be recognized by the Department for Promotion of Industry and Internal Trade (DPIIT).
The aggregate amount of the startup’s paid-up share capital and share premium (the additional amount paid by investors over the face value of the shares) cannot exceed INR 25 Crore after the proposed investment. However, the calculation of the paid-up capital shall not include the consideration received in respect of shares issued to a non-resident, a venture capital fund, and a venture capital company.
What is the Angel Tax Exemption Declaration?
Angel tax declaration is a formal statement submitted alongside your exemption application. It serves as a commitment from your startup to adhere to specific investment restrictions for a set period. The declaration outlines several asset categories where your startup cannot invest for a period of seven years following the end of the financial year when the shares are issued. These restrictions aim to ensure that the funds raised are used for core business purposes and not for personal gains. Here’s a breakdown of the restricted asset categories:
Residential Property: Investments in residential houses (except those used for business purposes or held as stock-in-trade) are prohibited.
Non-Business Land and Buildings: Land or buildings not directly used for business operations, renting, or held as stock-in-trade cannot be purchased.
Non-Business Loans: Loans and advances outside the ordinary course of your business are restricted (unless lending money is your core business).
Capital Contributions: Investing in other entities is not permitted.
Shares and Securities: Investments in other companies’ shares or securities are off-limits.
Luxury Vehicles: Vehicles exceeding Rs 10 lakh in value (except those used for business purposes) cannot be purchased.
Non-Business Assets: Investments in jewelry (outside of stock-in-trade), art collections, or bullion are prohibited.
The angel tax exemption declaration is a critical component of securing relief from the angel tax. By submitting this declaration, your startup demonstrates its commitment to responsible use of the raised funds, fostering trust with the government and investors.
Please ensure that the declaration is on the letterhead of the company.
How to Apply for Angel Tax Exemption?
Recognizing the complexities involved, the government has taken steps to simplify the process. Now, DPIIT-recognized startups can directly apply for angel tax exemption with the Department of Industrial Policy and Promotion (DIPP).
Login to https://www.startupindia.gov.in/ and insert your login credentials.
Click on the ‘Dashboard’ tab and then, click on ‘DPIIT RECOGNITION’.
Scroll down the page and come to Form 56, then click on ‘Click Here To Apply Form 56’.
Once the form opens, all details but: (i) point 9 (where you have to upload a signed declaration); and (ii) point 10 (declaration signing date), will be pre-filled, based on the information provided at the time of filing the Startup India registration.
Please ensure that the signed angel tax exemption declaration has complete and accurate details and that the declaration is on the company’s letterhead.
Upload the signed declaration in .pdf format and insert the date of signing of the declaration. Once done, click on ‘Submit’.
DIPP will then forward your application to CBDT, who are mandated to respond (approval or rejection) within 45 days of receipt. As a confirmation of the company having received the angel-tax exemption, the startup will receive an email from CBDT at the email ID submitted on the Startup India portal, within 1 to 3 weeks from the date of filing the application.
Applying for Angel Tax exemption? We handle documentation, valuation reports, and DPIIT coordination end-to-end. Let’s Talk
Benefits of Angel Tax Exemption
The angel tax exemption in India offers a breath of fresh air for both startups and angel investors. Here’s a breakdown of the key advantages:
Reduced Financial Burden: Exemption eliminates the hefty 30.9% tax on excess investment, allowing startups to retain more capital for growth.
Easier Access to Funding: Reduced tax liability attracts more angel investors, widening funding options for startups, especially in their crucial early stages.
Focus on Growth: Saved funds can be directed towards vital areas like product development, marketing, and team expansion, accelerating growth and innovation.
Disadvantages of Angel Tax for Startups in India
The angel tax, while intended to curb money laundering, has several drawbacks that hinder the growth of startups in India. Here’s a breakdown of its key issues:
Valuation Discrepancies: Unlike established companies, startups are valued based on future potential. This makes determining a fair market value (FMV) subjective. Subsequently taxing at a high rate (30.9%), potentially depleting crucial startup capital.
Discouraging Investment: The hefty angel tax rate discourages potential angel investors to fund promising startups due to the fear of a substantial tax bill, hindering the flow of essential funding for young companies.
Unequal Access to Capital: The angel tax initially only applies to investments from resident Indians. However, the updated regime includes the applicability of the exemption to foreign investors as well. Besides, no explicit inclusion of Non-Resident Indians (NRIs) is mentioned. Startups receiving funding from venture capitalists or Non-Resident Indians (NRIs) are exempt. This creates an uneven playing field, potentially limiting access to diverse funding sources for some companies.
Stifled Growth: A hefty angel tax bill can significantly impact a startup’s growth trajectory. Funds are diverted away from critical areas like product development, marketing, and hiring, hindering innovation and market competitiveness.
Angel Tax Example for Indian Startups
Imagine your startup’s revolutionary new app catches the eye of an angel investor who offers a substantial Rs 15 crore for shares. While this sounds like a dream come true, the Indian government might have a different take. If they value those shares at a lower Rs 10 crore, the difference (Rs 5 crore) is considered excess investment and taxed a hefty 30.9% under the angel tax. This unexpected Rs 1.54 crore tax bill can significantly impact funding, making the angel’s investment a double-edged sword for your young companies. However, if a startup is recognized and registered under the requisites of angel tax exemption, i.e., DPIIT startup recognition, it benefits from the significant tax liability that would otherwise be incurred on investments received at valuations higher than fair market value.
Conclusion
The angel tax in India, while initially intended to curb money laundering, has become a double-edged sword for startups. The high tax rate on investments exceeding the government’s Fair Market Value (FMV) assessment can significantly deplete crucial funding. However, the introduction of exemptions for DPIIT-registered startups offers a ray of hope. This exemption not only reduces the financial burden on startups but also fosters a more vibrant angel investor ecosystem by providing tax benefits to qualified investors. While some complexities remain in the application process, navigating them with the help of tax advisors can unlock the true potential of the exemption. Ultimately, striking a balance between encouraging legitimate investment and upholding tax regulations is key to fostering India’s burgeoning startup scene.
Common Mistakes Founders Make (And How to Avoid Them)
Mistake 1: Applying for Angel Tax Exemption Before Getting DPIIT Recognition
What founders do: Excited to fundraise, many founders try to apply directly for angel tax exemption without realizing they need DPIIT recognition first. This creates a chicken-and-egg problem, and their Form 56 application gets rejected immediately.
Why it matters: DPIIT recognition is a prerequisite, not optional. Without it, you have zero eligibility for exemption, and your application will be flat-out rejected within days.
How to fix it: Always follow the two-step process: (1) Get DPIIT recognition from the Department for Promotion of Industry and Internal Trade. (2) Only then apply for angel tax exemption via Form 56. The first step takes 30 to 60 days, so plan accordingly before raising capital.
Mistake 2: Ignoring the Rs 25 Crore Paid-Up Capital Cap
What founders do: Startups routinely exceed the Rs 25 crore aggregate cap on paid-up share capital and share premium (post-investment) without realizing it. They raise multiple rounds, add share premium freely, and suddenly discover mid-fundraise that they are ineligible.
Why it matters: Once you exceed Rs 25 crore, you cannot claim angel tax exemption, even if you have DPIIT recognition. The exemption is binary, all-or-nothing. This is especially painful for high-growth or venture-backed startups that cross this threshold fast.
How to fix it: Before each fundraising round, calculate your post-investment paid-up capital plus share premium. Keep a running cap table. If you are approaching the Rs 25 crore limit, plan accordingly. Foreign investor capital and VC fund investments are excluded from this calculation, so structure accordingly if possible. Consult your tax advisor to model different fundraising scenarios.
Mistake 3: Submitting an Incomplete or Unsigned Angel Tax Declaration
What founders do: Founders rush through the angel tax declaration, forget to print it on company letterhead, or submit it unsigned. CBDT rejects these outright. Many then resubmit the same incomplete document, wasting weeks.
Why it matters: The declaration is not a suggestion. It must be signed by an authorized director or signatory, on company letterhead, with the exact date of signing. A single missing element triggers automatic rejection.
How to fix it: Treat the declaration as a legal contract, because it is. Have your company secretary or director sign it in person. Print on official company letterhead with your company logo and registered address. Double-check that the signatory is authorized to sign (usually the MD or a director designated in board resolutions). Upload the PDF only after verifying all details are complete and the signature is legible.
Mistake 4: Not Understanding What Assets You Cannot Invest In for Seven Years
What founders do: Founders get exemption, then six months later buy a luxury vehicle for the company or invest in real estate thinking it is fine. Tax authorities flag it as a violation of the angel tax exemption declaration, and penalties follow.
Why it matters: The exemption declaration is binding for seven years from the end of the financial year in which shares were issued. Violating it nullifies your exemption and exposes you to back taxes plus penalties. The restrictions cover residential property, non-business land and buildings, luxury vehicles exceeding Rs 10 lakh, loans and advances outside ordinary business, capital contributions to other entities, and shares or securities in other companies.
How to fix it: Read the declaration carefully before signing. Understand that these are seven-year restrictions, not suggestions. Add a note in your finance or procurement policy that certain asset purchases are prohibited during the seven-year window. Brief your CFO and board on the restrictions. If you need to buy a vehicle or invest in assets, ensure it is directly for business purposes and documented as such.
Mistake 5: Underestimating the Fair Market Value (FMV) Problem
What founders do: Founders assume that as long as they have angel tax exemption, the FMV issue disappears. They raise at valuations way above any reasonable market comparable and assume they are protected. Then CBDT questions the valuation, and the founder realizes exemption does not mean immunity from scrutiny.
Why it matters: Even with exemption, tax authorities can challenge the valuation behind the investment. If the government’s FMV assessment is reasonable and your issue price is wildly inflated, exemption may not save you. Additionally, if you raise without proper valuation documentation, future investors and acquirers will question your cap table credibility.
How to fix it: Get an independent valuation report from a recognized valuator before fundraising. Use methodologies like discounted cash flow (DCF), comparable company analysis, or precedent transactions. If raising at a premium to FMV, document the reasons: strong product-market fit, impressive traction, talented team, large addressable market. When you apply for exemption, attach this valuation report to justify your issue price. This shifts the burden of proof to the government and makes challenges harder.
Mistake 6: Raising Money Before DPIIT Recognition Is Approved
What founders do: Founders close an investment round before DPIIT recognition comes through, assuming they can apply for exemption afterward. This is a critical timing error.
Why it matters: Exemption applications are evaluated based on the investment and DPIIT status at the time of filing Form 56. If you received investment before DPIIT approval, the exemption application becomes murky, and CBDT may interpret it as ineligible because your startup was not recognized when the investment was made.
How to fix it: Reverse the sequence: get DPIIT recognition first, then close the investment round. Yes, this adds 30 to 60 days to your fundraising timeline, but it eliminates legal and tax risk. Communicate with investors upfront that you are securing this approval first. Most serious investors understand and will wait. If they will not, it is a red flag about their sophistication.
Mistake 7: Forgetting About the Turnover Cap and Seven-Year Startup Window
What founders do: Founders get DPIIT recognition in year 2, raise Series A in year 4, and do not think to recheck eligibility. By year 8, they cross the Rs 100 crore turnover threshold and realize they are out of the 10-year startup window. If they need to raise again, they discover they are ineligible.
Why it matters: DPIIT recognition is valid only up to 10 years from incorporation. After that, you are no longer a startup and cannot claim exemption. Similarly, if turnover exceeds Rs 100 crore in any previous financial year, you lose startup status. This is a permanent disqualification for exemption purposes.
How to fix it: Mark your calendar on your incorporation anniversary minus one year. At year 9, understand that you are no longer eligible for new exemptions. If you are still raising capital and turnover is approaching Rs 100 crore, close funding rounds before that threshold. Work backward from your incorporation date and plan fundraising windows accordingly.
Mistake 8: Not Consulting a Tax Advisor Before Applying
What founders do: DIY-minded founders fill out Form 56 themselves, skip consulting a tax professional, and submit. Rejection comes within 45 days, and they waste critical time reapplying.
Why it matters: Angel tax exemption rules are complex, and CBDT has discretion in interpreting eligibility. A single misunderstanding about capital calculations, FMV methodology, or declaration language can sink your application. Tax advisors know the nuances and can anticipate CBDT objections.
How to fix it: Budget for a one-time consultation with a tax advisor (roughly Rs 10,000 to Rs 25,000) before submitting Form 56. They will review your cap table, valuation, DPIIT recognition documents, and declaration. They will catch mistakes that could cost you months and potentially hundreds of crores in tax liability. This is not optional for serious founders.
Mistake 9: Misunderstanding What “Non-Resident Investment” Means
What founders do: Founders assume non-resident investors (NRIs, foreign angels) are automatically exempt from triggering angel tax. They are not. The rules are nuanced: investments from non-residents and VC funds are excluded from the Rs 25 crore paid-up capital calculation, but the investment itself may still trigger angel tax on the startup if FMV is exceeded.
Why it matters: This confusion leads to either underestimating the impact on your cap table or miscalculating whether you are still under the Rs 25 crore cap. Either way, you file inaccurate applications.
How to fix it: Get clarity on the specific rule: non-resident and VC fund investments are excluded from the paid-up capital cap calculation (helping you stay under Rs 25 crore), but the startup still needs exemption if the issue price exceeds FMV. Work with your tax advisor to structure rounds accordingly.
Mistake 10: Filing Form 56 Without a Clear Picture of Your Entire Cap Table
What founders do: Founders file exemption applications based on a single investment round, forgetting about ESOP pools, sweat equity, or previous rounds. CBDT reviews the full cap table, spots inconsistencies, and rejects the application for incomplete information.
Why it matters: Form 56 requires disclosure of all shares issued, valuations, and cumulative paid-up capital. Omitting even one previous round or not accounting for ESOP dilution makes your application incomplete.
How to fix it: Before applying, build a complete and accurate cap table showing every share class, round, valuation, and issuance. Have your company secretary or cap table manager verify it. Share it with your tax advisor. Only then file Form 56. This foundational work takes a day but prevents weeks of delays and rejections.
Final Takeaway
Angel tax exemption is powerful when executed correctly, but the process demands precision. Get DPIIT recognition first, maintain accurate cap tables, keep valuations defensible, and treat the declaration as binding. Work with a tax advisor, plan your fundraising timeline around the 30 to 60-day DPIIT window, and verify eligibility before you raise a single rupee. The difference between a smooth exemption approval (1 to 3 weeks) and a frustrating rejection (45 days wasted) often comes down to these foundational steps. Start early, document everything, and you will unlock significant tax relief for your startup.
