Concept of Angel Tax & Taxability under Income Tax Act 1961

 As you are aware that finance is the most important driving force in our society and the country. Your bank balance determines your status in the society. Your living of standard shows your financial position and your acceptance in the society and your relatives. So finance is the most important aspects of a human life. Same concept is applicable in commercial line also or in business environment. A person having innovative, new, useful idea if do not have money or finance , then he is not able to show his ideas/thoughts /products to the people and hence there is no value of thoughts unless it comes by way of some work in the market.

 

Same way our new entrepreneurs , developers, IT professionals etc., have new thoughts , ideas, and inventions but they lack financial support. Here “ Angel Investors” enters , these are High Wealth Individuals ( HNIs) generally belong to rich families or officers of various multinational organisations ,who have resigned from their jobs and are in search of eligible entrepreneur and Start-ups to invest their money and earn appropriate returns.

 

Essentially these individuals both have the finances and desire to provide funding for start-ups. This is welcomed by cash-hungry start-ups who find angel investors to be far more appealing than other, more predatory, forms of funding.

 

The term “angel” came from the Broadway theatre, when wealthy individuals gave money to propel theatrical productions. The term “angel investor” was first used by the University of New Hampshire’s William Wetzel, founder of the Centre for Venture Research. Wetzel completed a study on how entrepreneurs gathered capital.

 

 

LET’S DEFINE -ANGEL INVESTOR

 

INVESTOPEDIA –An angel investor (also known as a private investor, seed investor or angel funder) is a high-net-worth individual who provides financial backing for small start-ups or entrepreneurs, typically in exchange for ownership equity in the company. Often, angel investors are found among an entrepreneur’s family and friends. The funds that angel investors provide may be a one-time investment to help the business get off the ground or an ongoing injection to support and carry the company through its difficult early stages.

 

 

KEY TAKEAWAYS

• An angel investor is usually a high-net-worth individual who funds start-ups at the early stages, often with their own money.
• Angel investing is often the primary source of funding for many start-ups who find it more appealing than other, more predatory, forms of funding.
• The support that angel investors provide start-ups fosters innovation which translates into economic growth.
• These types of investments are risky and usually do not represent more than 10% of the angel investor’s portfolio.

 

 

WIKEPEDIA- An angel investor (also known as a business angel, informal investor, angel funder, private investor, or seed investor) is an individual who provides capital for a business or businesses start-up, usually in exchange for convertible debt or ownership equity. Angel investors usually give support to start-ups at the initial moments (where risks of the start-ups failing are relatively high) and when most investors are not prepared to back them.

 

PLEASE NOTE THAT from discussion we conclude that an “ Angel Investor” is informal investor, angel funder, private investor who is a Wealthy Individual or HNIs or retired employees of multinational companies having huge wealth and provide capital to start-ups in exchange of equity ownership or debt instruments. These investors generally provide seeding capital or initial capital to a start-up entity to earn health profit or capital appreciation of investment once start-ups come into operations and exist from the start-ups.

 

THE STARTUP INDIA CAMPAIGN WAS LAUNCHED IN 2016 in order to increase entrepreneurship and build a strong and inclusive ecosystem for innovation in India.

 

Through this campaign, various aspects of running a start-up, such as bank financing, tax exemptions, simplifying the process of registering the business and other benefits were targeted, in order to make running a business more appealing to India’s youth.

 

ELIGIBILITY CRITERIA FOR STARTUP RECOGNITION:

i. The Start-up should be incorporated as a private limited company or registered as a partnership firm or a limited liability partnership.

 

ii. An entity shall be considered as a start-up up to 10 years from the date of its incorporation.

 

iii. Turnover should be less than INR 100 Crores in any of the previous financial years.

 

iv. The company remains a start-up if the turnover per year does not cross the Rs 100 crore marks in any of the 10 years. Once the company crosses the mark, it no longer remains eligible to be called a start-up. The mark of Rs 100 crore too has been improved by the Indian government in the recent past from Rs 25 crore.

 

v. The firm should have approval from the Department of Industrial Policy and Promotion (DIPP).

 

vi. The Start-up should be working towards innovation/ improvement of existing products, services and processes and should have the potential to generate employment/ create wealth.

 

vii. An entity formed by splitting up or reconstruction of an existing business shall not be considered a “Start-up.”

 

 

BENEFITS AVAILABLE TO AN ELIGIBLE START-UP

1. Following benefits shall be available to an eligible start-up or its shareholders:

2. Exemption from levy of angel tax under section 56(2)(viib);

3. Deductions under section 80-IAC of the income tax Act;

4. Liberalized regime of section 79 to carry forward and set-off the losses

5. Exemption under section 54GB to the shareholder for making investment in a startup;

6. Access to the dedicated cell created by the CBDT to address the problems of start-ups.

 

 

Tax Exemption under Section 80 IAC of the income Tax Act, 1961 for Start-up Post getting recognition a Start-up may apply for Tax exemption under section 80 IAC of the Income Tax Act. Post getting clearance for Tax exemption, the Start-up can avail tax holiday for 3 consecutive financial years out of its first 10 years since incorporation.

 

 

Eligibility Criteria for applying to Income Tax exemption (80IAC):

• The entity should be a recognized Start-up;
• Only Private limited or a Limited Liability Partnership is eligible for Tax exemption under Section 80IAC;
• The Start-up should have been incorporated after 1st April, 2016 but before April 1, 2021

 

 

Profit Exemption to eligible Start-up entities under Section 80-IAC: Deduction at the rate of 100% of its profits and gains is allowed to an eligible start-up for 3 consecutive assessment years out of the 7 years (10 years from 01.04.2020) beginning from the year of incorporation.

 

As per Section 80-IAC, an entity shall be considered as an eligible start-up if it fulfils following conditions:

• It is incorporated as a company (Private Ltd. Co. or Public Ltd. Co.) or an LLP.
• It is incorporated on or after April 1, 2016 but before April 1, 2021.
• Its turnover does not exceed Rs.25 Cr (Rs.100 Cr from 01.04.2020) in the previous year relevant to assessment year for which such deduction is claimed.
• It is not formed by splitting up or reconstruction of a business already in existence.
• It holds a certificate of eligible business from the Inter-Ministerial Board of Certification.
• It is engaged in innovation, development or improvement of products or processes or services or a scalable business model with a high potential of employment generation or wealth creation.

 

Note: For Claiming under section 80-IAC , A recognized start-up is required to file Form 1 along with the specified documents to the Inter-Ministerial Board of Certification. The board may call for certain documents or information and may make such enquiries, as it deems fit, to recognize the entity as an eligible start-up and grant a certificate for claiming exemption under section 80-IAC. The board may reject the application by providing the reasons thereof.

 

 

ANGEL TAX UNDER SECTION 56(2)(VIIB) OF THE INCOME TAX ACT –

Angel tax is the tax charged on the closely held company when it issues shares to a resident person at a price which is more than its fair market value. When this provision is triggered, the aggregate consideration received from issue of shares as exceeds its fair market value is charged to tax under the head ‘Income from other sources’ under section 56(2)(viib).

 

 

Tax Exemption under Section 56 of the Income Tax Act (Angel Tax)

Post getting recognition a Start-up may apply for Angel Tax Exemption. A start-up shall be eligible for claiming exemption from levy of angel tax under section 56(2)(viib) if following conditions are satisfied:

• The entity should be a recognized Start-up;
• Aggregate amount of paid up share capital and share premium of the Start-up after the proposed issue of share, if any, does not exceed INR 25 Crore.

 

 

THE MAIN REASON FOR THE INTRODUCTION of the ‘Angel Tax’ was to tax the excessive share premium received over and above the FMV by the private companies, which was extensively being used as a mechanism for accounting for unaccounted money or black money. Thus, this is one of the anti-abuse provisions introduced to prevent money laundering.

 

 

LET’S CONSIDER – What Section 56(2) (viib) says-

“Where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:

 

Provided that this clause shall not apply where the consideration for issue of shares is received-

 

• ·By a venture capital undertaking from a venture capital company or a venture capital fund or a specified fund; or

 

• · By a company from a class or classes of persons as may be notified by the Central Government in this behalf;

 

 

ANALYSIS OF SECTION 56(2) (VIIB)

As it is clear from the reading of the section that the above section is applicable in case of a closely held company or private limited company where it is in receipt of consideration of issuance of shares at a premium that is in excess of its fair market value (FMV).

 

In other words, the private limited companies in India should ensure that they issue shares to any other person resident in India at its FMV which may be determined using the Net Asset Value Method or any other prescribed method. In case the shares are issued by them at a price in excess of the FMV, the implications of section 56(2) (viib) will get triggered and the company shall be liable to pay tax on such excess premium received by it.

 

 

Please keep in mind that the above provision is applicable only where the private limited company receives consideration for the issue of shares from a person resident in India. If such a company receives an excess premium in case of issue of shares to a non-resident, the tax implications of section 56(2) (viib) will not come into play.

 

However, the above section shall not be applicable where the consideration of the issue of shares is received by a venture capital undertaking from a venture capital company or a venture capital fund or a specified fund. Further, the Central Government may also notify the class of persons on which the aforesaid section shall not apply.

 

 

HOW TO GET EXEMPTION FROM ANGEL TAX

To exempt start-ups from the implications of section 56(2)(viib), the Government issued a notification dated 19.02.2019 that section 56(2)(viib) shall not apply if an approved eligible start-up company receives consideration for the issue of shares from resident investors. However, this is subject to fulfilment of certain conditions which we will discuss in this article. It is to be noted that receiving consideration for the issue of shares from non-residents is already out of the ambit of section 56(2) (viib).

 

 

CHECK ELIGIBILITY OF STARTUPS AS BELOW:

A start-up shall be eligible for the exemption from Angel Tax if it has been recognized by DPIIT and the aggregate amount of its paid-up share capital and share premium of the start-up after issue or proposed issue of shares does not exceed INR 25 crores.

 

Further in the calculation of threshold of INR 25 crores, the amount of paid-up share capital and share premium in respect of shares issued to any of the following persons will not be included:

 

• A Non-resident or
• A Venture Capital Company pr
• A Venture Capital Fund

 

Note: Therefore, if you are a start-up and you are registered with DPIIT & your capital including premium does not exceed Rs. 25 crores, you are eligible for exemption from Angel Tax.

 

 

CONDITIONS FOR EXEMPTION FROM ANGEL TAX TO BE FULFILLED

An eligible start-up shall get exemption from Angel Tax as given u/s 56(2) (viib). However, the exemption is provided subject to the condition that the start-up should not invest, within 7 years from the end of the latest financial year in which the shares are issued at a premium, in any of the following:

 

• Building or land for the purpose (other than own use or as stock in trade or for the purpose of renting);
• For advancing loans (other than where the lending of money is the substantial part of the business of the start-up);
• Capital contribution to any other entity;
• Shares and securities;
• Motor Vehicle, aircraft, yacht, or any other mode of transport, the actual cost of which exceeds INR 10 Lakhs (other than that held by the start-up for the purpose of plying, hiring, leasing, or as stock-in-trade, in the ordinary course of business;
• Jewellery (other than that held by the start-up as stock in the ordinary course of business);
• Archaeological collections & Artifacts etc.

 

 

PLEASE NOTE THAT

• As read above, the start-ups are not eligible for exemption from Angel Tax if they give loans and advances. Thus, the start-ups are barred from even advancing advances and loans to employees. This might also lead to unnecessary litigation by the Income Tax Department and is thus a constraint for the start-ups.
• Start-ups are barred from making a capital contribution to any other entity. This again creates obstacles for companies, looking to expand their operations through mergers and acquisitions or setting up subsidiaries.

 

 

CONSEQUENCES OF FAILURE TO FULFILL CONDITIONS FOR EXEMPTION FROM ANGEL TAX SECOND PROVISO TO SECTION 56(2) (VIIB) READS AS BELOW:

“Provided further that where the provisions of this clause have not been applied to a company on account of fulfilment of conditions specified in the notification issued under clause (ii) of the first proviso and such company fails to comply with any of those conditions, then, any consideration received for issue of share that exceeds the fair market value of such share shall be deemed to be the income of that company chargeable to income-tax for the previous year in which such failure has taken place and, it shall also be deemed that the company has under-reported the said income in consequence of the misreporting referred to in sub-section (8) and sub-section (9) of section 270A for the said previous year.”

 

Analysis:

 

• If any eligible start-up fails to comply with the conditions as referred in the Notification, the exemption from Angel Tax allowed to such start-up earlier shall be revoked.

 

• The effect of the revocation is that any consideration received before failure by such start-up which is in excess of the fair market value of shares will be deemed to be the income of the start-up for the financial year in which exemption is revoked.

 

• Further, it shall be deemed that the start-up has under-reported its income and shall be liable for consequences u/s 270A i.e. penalty equal to 200% of the amount of tax payable on under-reported income.

 

 

PLEASE NOTE THAT

Though section 56(2)(viib) has been brought by the Government to prevent the incidents of money laundering and the Government has certainly allowed various exemptions to start-ups through notification, still, certain provisions of the section are harsh for genuine start-ups. The Government should look into those and allow the following relaxations so that start-ups could thrive in a conducive growth environment:

 

• Reduction of the time limit from 7 years for certain conditions like investment in the capital of other entities.
• Extending threshold limit of INR 25 crores.
• Allowing loans & advances by start-ups to fulfil genuine business needs.

 

 

For the purpose of this Section 56(2)(viib)- Fair Market Value shall be the value, Higher of the following:

(a) as may be determined in accordance with such methods as may be prescribed( Methods prescribed under Rule 11UA are Book value Method (NAV) and Discounted Cash flow method); or

 

(b) as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature, In Rule 11UA(2)(b) the fair market value of the unquoted equity shares shall be determined by a merchant banker or an accountant as per the Discounted Free Cash Flow method.

 

 

LET’S CONSIDER AN EXAMPLE FOR UNDERSTANDING ABOVE PROVISIONS

 

M/s. ABC Pvt. Ltd. Is an start-ups and engaged in the business of providing innovative products and have got approval of start-ups from Department of Industrial Policy and Promotion (DIPP). The initial the Authorised Share Capital is of Rs. 2,00,000 Lakhs divided in to 50000 Equity Shares of Rs. 10/- each and Paid Up Capital is Rs. 5,00000/- Lakhs. The company was incorporated on 01.04.2020 and Mr. X an angel investors wants to acquire 20,000 , Equity Shares of the company on 01.04.2022 at Rs. 250/- per share. The valuation done and valuation report of Auditor has been received under Rule 11UA(2)(b) and FMV at the time of acquisition was Rs. 200/- per share.

 

 

NOW DETAILS ARE GIVEN BELOW:

 

1. Nominal Price of Equity Share- Rs. 10/- Equity Shares;
2. Fair Market Value of Equity Share on 01.04.2022 – Rs. 200/- per share;
3. The Sale Consideration of shares on 01.04.2022- Rs. 250/- per shares.

 

 

The Angel Tax

Premium Received by M/s. ABC Pvt. Ltd. On issue of Share Rs.( 250-200)=Rs. 50/Equity Shares.

 

 

Total Premium Received= Rs. 50* 20000= Rs. 10,00,000/- will be taxable in the hand of M/s. ABC Pvt. Ltd, as Income from Other Sources. Which has been exempted for eligible start-ups and the Angel Investors fulfilling specified criteria.

 

CONCLUSION

 

Please consider

 

1. The income tax relief impacts the start-ups which are approved by the inter-ministerial panel, where the paid-up capital and share premium of the beneficiary company doesn’t exceed INR 10 crore after the issuing of shares. This notification is effective retrospectively from 11th April 2018.

 

2. Angel investors planning to subscribe shares in a start-up would require fulfilling specified criteria and the start-ups would need to procure the report from the Merchant Banker or Chartered Accountants which would specify the fair market value of such shares as per the income tax rules.

 

3. As per the income tax notification, angel investors with the minimum net worth of INR 2 crore or the average returned the income of more than INR 25 lakhs in the previous 3 financial years will be eligible for 100 % tax exemption on the investments that are made in the start-ups above the fair market value.

 

4. Many start-ups have raised their concerns over taxation of the angel funds under the provisions laid down under Section 56 of the Income Tax Act, 1961. This section required taxing the funds received by an entity. Around 18 start-ups received the notices from income tax authorities. Start-ups that are incorporated on or before April 2016 could seek the exemptions from this section.

 

5. However, the 3-year income tax concession is available to the start-ups that have been incorporated after 1st April 2016. Start-ups enjoy the income tax benefit for 3 out of 7 successive AYs (assessment years) under the Income Tax Act.

 

6. The Indian government so far has extended the tax benefits to only 88 start-ups which have been recognized by Department of Industrial Policy and Promotion since January 2016. For availing both the concessions i.e. exemption from tax on funds and exemption of tax from 3 years, start-ups need to approach the inter-ministerial board of certification.

 

7. The notification is considered a welcome move in dispelling fears of the start-ups with respect to angel tax and providing much-required clarity in relation to non-applicability of the angel tax. Further, this decision to provide an exemption to investors in start-ups from the income tax was intended to address a major issue that was faced by the angel investors who were investing their money during the early times of gestation and growth. This exemption will provide a level playing field for the investors.

 

8. The other key takeaway was the amendment with respect to the issue of valuations reports by Chartered accountants for angel tax purposes. The Central Board of Direct Taxes (CBDT) has amended the Rule 11 UA (2)(b) of the Income Tax Act, 1961, thus making the valuation by merchant bankers compulsory for determining the fair market value of the unquoted equity shares.

 

 

DISCLAIMER: the article presented here is for sharing information and knowledge to the readers. The views are personal and in case of necessity do consult with tax professionals.

 

 

11th May, 2022.