New Delhi: India’s startups have high hopes from the first budget of Modi 3.0 as it was Prime Minister Narendra Modi who launched Startup India and Standup India schemes for Indian entrepreneurs in his first term. Though the government has announced several schemes for startups over the years, a contentious issue, the issue of angel tax, continues to haunt entrepreneurs and startup founders. Startups are demanding the abolition or a complete overhaul of this tax levied under Section 56(2)(viib) of the Income Tax Act of 1961.
This tax is so contentious that several leading economists and entrepreneurs joined the voice ahead of this year’s budget seeking its removal.
The Department of Industrial Policy and Promotion (DPIIT), the nodal body under the Ministry of Commerce and Industry, for recognising the startups to avail the tax benefits under government schemes, also urged the Finance Ministry to abolish the angel tax on startups in this budget.
The department has reasons to be concerned as the funding for the startups in the first six months of this year fell by nearly four per cent to a little over 5 billion US dollars.
What is angel tax on startups?
The history of this contentious tax dates back to 2012 when the government introduced a tax under Section 56(2)(viib) of the Income Tax Act on the unlisted startups raising capital from angel investors or venture capitalists if the value of investment exceeded the fair market value for that startup company’s stocks.
As a result, the value of a startup, exceeding the fair market value as determined by the assessing officer, was treated as income and taxed at the rate of 30 per cent.
For example, a group of founders float a new private limited company with an authorised share capital of Rs 1 lakh and the entire share capital is issued, subscribed and paid up by them in the form of shares of face value of Rs 10 each, which means 10,000 shares with face value of Rs 10 each.
Then this startup, which has been incorporated in the form of a new private limited company, brings in an investor due to their novel business idea or some innovation or goodwill or some technical know-how or some other intangible asset, and the investor is willing to acquire 10 per cent stake in the startup for a value of Rs 20 crore, valuing the total startup at Rs 200 crore.
It means the investor has valued a 10 rupee share of the company at Rs 2,000, a premium of Rs 1990 per share over its face value.
In such a situation, an income tax officer would tend to levy income tax under Section 56(2)(viib) at the rate of 30 per cent, treating the premium as income rather than investment as apparently the investment exceeds the fair market value.
The government diluted the section for startups
The issue of the levy of income tax on startup companies gained media attention during the previous Lok Sabha election in 2019 as opposition parties also opposed the move.
As a result, Finance Minister Nirmala Sitharaman subsequently diluted some provisions of Section 56 as it exempted those investments received by a venture capital company or fund or other class of persons specified by the government.
However, it is the responsibility of the startup company to comply with the conditions imposed by the government or substantiate before the assessment officer that it is a venture capital investment and not income otherwise the startup company will still be liable to pay income tax if it exceeds the fair market value of its stocks.
Risk of corruption and money laundering
On the other hand, the abolition of income tax on startups under Section 56 of the Act may lead to cases of money laundering and corruption where a new company is floated and receives a huge premium for its shares that exceed its fair market value.
In the past, it came to the knowledge of investigating authorities that proceeds of corruption or crime were invested into newly floated companies at exorbitant premiums, which did not justify the fair market value of such investments.
Why are startups seeking the abolition of angel tax in the budget?
This is a tricky situation for any startup to lose 30 per cent of the received investment from angel investors or venture capital companies as income tax.
Though the government has inserted safeguards over the past few years to prevent harassment of startups it has not ended the problem, but startups are against it saying it’s a tax on capital and not on income, which is unique to India.
That is why this year the DPIIT also recommended the abolition of income tax on startups under Section 56(2)(viib) of the Act. The department also forwarded the industry representations to the Finance Ministry to take a holistic view of the problem of angel tax.
Read more: Indian Startup Ecosystem: Key drivers of economic growth
