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Angel Tax Exemption – Eligibility, Declaration, How to Apply

Posted on by Treelife

India’s startup landscape has become an ongoing global success story, attracting a swarm of investors eager to tap into its potential. From angel investors to venture capitalists, everyone’s looking for the next big thing. But there’s a hidden hurdle for young companies: the angel tax.

Angel tax was introduced in the Finance Act, 2012 and came into force post-April 2013. It requires startups to pay taxes on the difference between the investment amount they receive and the fair market value determined by the government.  The difference between the issue price of the shares and the FMV as determined by the tax authorities is treated as income from other sources and taxed at the prevailing income tax rate. This can be a significant financial burden for startups, especially those in their early stages. Determining a fair market value for a budding startup is notoriously difficult. While the government introduced some exemptions in the Union Budget of 2019, strict conditions apply. This has created a situation where a well-intended tax regulation aimed at curbing money laundering has unintentionally become a roadblock for many legitimate startups.

In this article, we will understand the intricacies of angel tax, the exemptions allowed under India’s tax regime, and the potential reasons behind angel tax becoming a breakthrough in the fast-paced entrepreneurial spirit of our country. 

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 aren’t publicly traded) that receive funding exceeding the Fair Market Value (hereinafter ‘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 ₹15 crore for shares whose FMV is estimated at ₹10 crore by the government. Under the angel tax, that ₹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: 

  1. Eligibility Criteria for Startup Recognition
  2. 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 ₹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.

Download the Angel Tax Declaration template here 

(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 & 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’.

angel tax exemption

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 1-3 weeks from the date of filing the application.

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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 ₹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 ₹10 crore, the difference (₹5 crore) is considered excess investment and taxed a hefty 30.9% under the angel tax. This unexpected ₹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.



Frequently Asked Questions (FAQs) for Angel Tax and its Exemption

Q: What is the angel tax?

The angel tax applies a levy on startups that receive investments exceeding the Fair Market Value (FMV) determined by the government. This difference between the investment amount and FMV is taxed at a rate of 30.9%.

Q: When was the angel tax introduced?

The angel tax emerged in India with the Finance Act of 2012, aiming to curb money laundering through inflated startup valuations. Inflated valuations of startups were seen as a potential channel for black money.

Q: How does the angel tax impact startups?

The high tax rate on the FMV difference discourages potential angel investors and depletes crucial funding for startup growth.

Q: What are the benefits of angel tax exemption?

Exemption from the angel tax reduces the financial burden on startups, allowing them easier access to funding and a sharper focus on core business activities.

Q: How can a startup get exempt?

DPIIT registration and an application to the CBDT for exemption are required.

Q: What are the eligibility criteria for exemption?

  • DPIIT registration
  • Capitalization under Rs. 25 crore
  • Investment from specific sources (not all trigger the tax)
  • Annual turnover below Rs. 100 crore

Q: What does the angel tax exemption declaration entail?

The declaration is a commitment from the startup to refrain from investing in certain assets (luxury vehicles, real estate) for a period of seven years following the investment.

Q: How has the angel tax policy changed?

The 2019 Union Budget introduced exemptions, and ongoing reforms aim to create a more balanced approach.

Q: What are the challenges with angel tax benefits?

The application process can be complex, and FMV assessment can be subjective. Consulting tax advisors is highly recommended.

Q: What’s the future of the angel tax?

Reforms are expected to simplify the process and encourage a more vibrant angel investor ecosystem for India’s booming startup scene.

Why do angel investors and VC funds ask for preference shares in a funding round?

Posted on by Treelife

In this blog, we will discuss the reasons why investors ask companies to issue preference shares during their funding rounds. We’ll also cover what preference shares are, their features, and their types.

Section 43 of the Companies Act, 2013 states that

(ii) “preference share capital‘‘, with reference to any company limited by shares, means that part of the issued share capital of the company which carries or would carry a preferential right with respect to— (a) payment of dividend, either as a fixed amount or an amount calculated at a fixed rate, which may either be free of or subject to income-tax; and

(b) repayment, in the case of a winding up or repayment of capital, of the amount of the share capital paid-up or deemed to have been paid-up, whether or not, there is a preferential right to the payment of any fixed premium or premium on any fixed scale, specified in the memorandum or articles of the company;

(iii) capital shall be deemed to be preference capital, notwithstanding that it is entitled to either or both of the following rights, namely: —

(a) that in respect of dividends, in addition to the preferential rights to the amounts specified above, it has a right to participate, whether fully or to a limited extent, with capital not entitled to the preferential right aforesaid;

(b) that in respect of capital, in addition to the preferential right to the repayment, on a winding up, of the amounts specified above, it has a right to participate, whether fully or to a limited extent, with capital not entitled to that preferential right in any surplus which may remain after the entire capital has been repaid.”

From the above definition, we can understand that Preference Shares are those shares that are given priority over other equity shares. Preference Shares are held by preference shareholders who get the right to receive the first payouts in case the company decides to pay its investors any dividends. Another way to understand preference shares is those shares whose shareholders have the right to claim dividends during the lifetime of a company. The same shareholders also can claim repayment of capital in case the company is wound up or liquidated. These shares combine the characteristics of debt and equity both.

Preference shares are given priority over other equity shares and are held by preference shareholders who receive the first payouts in case the company pays its investors any dividends. These shares also provide a preferential right to claim dividends during the lifetime of a company and the repayment of capital if the company is liquidated. The features of preference shares:

  1. Dividend payouts: Preference shares allow holders to receive dividend payouts when other stockholders may not receive any dividends or receive them later. The payouts can be fixed or floating based on the interest rate benchmark.
  2. Preference in assets: When the company is liquidated or wound up, preference shares get priority over non-preferential shareholders when claiming the company’s assets.
  3. Voting rights: Preference shares generally do not carry voting rights, but preference shareholders may be allowed to vote in specific events that directly affect their rights as holders of preference shares.
  4. Convertibility: Preference Shares can be converted into ordinary equity shares. They are typically converted into a predetermined number of non-preference shares after certain trigger events.

Types of preference shares:

  1. Convertible preference shares: Convertible Preference Shares allow shareholders to convert their Preference Shares into equity shares at a fixed rate after a specified period.
  2. Non-convertible preference shares: These shares cannot be converted into equity shares and only receive fixed dividend payouts.
  3. Redeemable preference shares: Redeemable Preference Shares can be repurchased or redeemed by the company at a fixed rate and date.
  4. Irredeemable preference shares: Irredeemable Preference Shares cannot be redeemed during the company’s lifetime.
  5. Participating preference shares: These shares allow shareholders to demand a part in the surplus profit of the company at the event of liquidation after the dividends have been paid to other shareholders.
  6. Non-participating preference shares: These shares only offer fixed dividends and do not provide shareholders with the additional option of earning dividends from the surplus profits earned by the company.

The prime reason investors ask for Preference Shares is the security it offers them, especially when investing in early-stage startups. Preference Shares provide a participating liquidation preference that grants the investor a right to receive its funds in a liquidation event, with the balance of the proceeds being shared ratably amongst the holders of the equity shares and Preference Shares. In a non-participating liquidation preference, the preference holder will receive its predetermined returns, but will not receive any portion of the remaining proceeds.

FACTS: 

Startup- ABC Private Limited

Investor-XYZ Ventures,

Investment amount: USD 5 million for 20 percent of the equity in the Startup with a predetermined liquidation preference of 1x of the Investment Amount. (this typically ranges from 1x to 1.5x depending on the deal size)

Liquidation Event Proceeds = USD 100 million

  1. As per Non-participating Liquidation Preference, XYZ Ventures will have the option to take the greater of USD 5 million or 20 percent of USD 100 million.  Here, XYZ Ventures will opt for the latter and take away USD 20 million;
  2. As per the Participating Liquidation Preference, XYZ Ventures will have the right to take USD 5 million first and then partake 20% in the remaining USD 95 million as well. This totals the aggregate amount of return to XYZ Ventures to USD 24 million (USD 5 million + 20% of USD 95 million).

In practice, an event of liquidation is not limited to “winding up”, under the Companies Act, 2013. It usually includes any merger or consolidation of the company in which its shareholders do not retain a majority of the voting power in the surviving entity, the sale of all or substantially all of the company’s assets, and any other transaction constituting a change of control or even an initial public offer.

If the company has to be wound up, then to ensure the protection of their money, an investor would prefer to have preferential rights at the time capital is repaid. Here, preference shareholders have an edge over equity shareholders. The priority of repayment in the course of winding up is statutorily prescribed, such that shareholders may be repaid only after all outstanding liabilities of the company have been discharged. The Companies Act, 2013  provides that, with regard to capital, Preference Shares carry or will carry on winding up or repayment of capital a preferential right to be repaid the amount of the capital paid up or deemed to have been paid up, whether or not there is a preferential right to the payment of either or both of the following amount: (i) any dividend remaining unpaid up to the date of winding up or repayment of capital; and (ii) any fixed premium or premium on any fixed scale, specified in the company’s charter documents.

An investment agreement usually includes provisions that provide an assured exit to the investors at a fixed return post a specified period. However, the need for liquidation preference protection arises in scenarios where a liquidation event takes place prior to the investor being provided an exit. In such a case it is essential that the investor receives a return on its investment and such a clause is included in an investment agreement.

Anti-dilution –

Another practical benefit of preference shares is that they provide ‘down round’ protection to the investor. In India, the two commonly used forms of anti-dilution protection are: (a) Full Ratchet and (b) Broad-Based Weighted Average.

A Preference Shareholder has the option to require the company to protect its interest in the event the company issues shares in the subsequent rounds at a price lower than the price of the investor’s share. This is achieved by conversion of the existing Preference Shares of the investor into such number of equity shares, or by issuing a further number of Preference Shares to the company at a lower value, such that the shareholding percentage of the investor does not take a hit.

Dividends –

“The first rule in investing: don’t lose any money. The second rule: don’t forget the first rule!” as quoted by Warren Buffet on an occasion.

Since the prime reason for all investments is returns, it is only prudent to investigate the nature of the instrument in respect of returns. While most investments are done looking at the returns being received via the enhanced value of the shares at the time of exit, it is also prudent to also look at dividends.

A Preference Share gives a preferential right in regard to dividends under the Companies Act, of 2013. An interesting fact is that the provision relating to Preference Shares under the Companies Act only contemplates the payment of a fixed amount or an amount calculated at a fixed rate, in preference to the equity shareholders of a company. The provision does not mention the time period within which a dividend has to be paid. Therefore, the investor is free to contractually require the company to pay not only a dividend in preference to other shareholders but also to require the company to pay a dividend on a year-on-year basis, rather than as and when declared.

Conclusion

The characteristics and the understanding of how Preference Shares are beneficial to the investors lead us to conclude that Preference Shares are a perfect mechanism to protect the interest of the investors who are making an investment in startups and taking on the risk associated with such investments.

We can conclude that the liquidation preference that these Preference Shares provide to the investors (which is incorporated in the investment agreements in the language acceptable to the investor) becomes one of the prime reasons for them asking for Preference Shares.

However, dividends and anti-dilution are also equally important factors. Dividends are primarily important because investors are majorly interested in protecting cash flows through dividends than returns.

Based on the above discussion we can conclude a Preference Share can be customized to the needs of the investor, making Preference Shares a more attractive solution for investments than equity or debt. However, it is always advisable for investors to invest in a few equity shares as well in order to maintain their voting rights.

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