Emerging and creative startups often seek opportunities for funding. There is a diverse range of investors available to assist startups in building their business strategies. Under the startup India Scheme, there are several advantages, and one of them is the exemption from angel tax. This provision enables startups acknowledged by the Department for Promotion of Industry and Internal Trade (DPIIT) to secure investments from angel investors while enjoying a tax exemption.
What is angel tax?
Startups are known for their innovation and the determination of their entrepreneurs, yet a significant hurdle they often face is the lack of sufficient working capital. This scarcity of funds frequently translates to inadequate cash flow, prompting startups to seek external investors. During this pursuit, many entrepreneurs discover that engaging angel investors is more feasible than securing funding from larger venture capital firms. The rationale behind this preference lies in the fact that angel investors, who are affluent individuals, actively seek opportunities to invest their wealth in ways that foster the growth of startups.
In accordance with Section 56 (2) (viib) of the Income Tax Act, the term “angel tax” refers to the tax liability imposed on privately held companies when they issue shares at a valuation exceeding the fair market value. This situation often arises when startups that experience rapid growth decide to issue shares at a premium. The amendment introducing this provision was proposed in 2012 by regulatory authorities to counter the rising occurrence of money laundering activities.
In essence, startups’ innovative spirit and the diligence of their founders are often hampered by limited financial resources. Seeking external investment, especially from angel investors, is a common approach to address this challenge. However, the imposition of angel tax, as defined in Section 56 (2) (viib) of the Income Tax Act, can complicate matters by imposing taxes on share issuance valuations that exceed fair market values. This regulatory measure was initially introduced in 2012 to curb the growing problem of money laundering activities.
Angel tax exemption for startups
Various categories of investors were subject to different tax regulations in India. For instance, while angel investors faced significant charges on their invested funds, foreign investors and venture capital firms were not subjected to the same taxes, as specified in section 56 (2) (viib) of the regulations. This seemed to create a contradiction where the government aimed to streamline business processes through DPIIT reforms, yet startups faced substantial taxes upon achieving success. As a response to this situation, the DPIIT introduced the Angel Tax Exemption in 2019, primarily benefiting startups that received recognition. This exemption relieved startups from tax obligations on angel investments they secured.
However, not all startups could benefit from this tax exemption. Only specific entities met the criteria for applying for angel tax exemption in India:
- Startups recognized by the DPIIT
- Startups with an aggregate amount of paid-up share capital/premium lower than INR 25 crores after issuing shares, if applicable
- Startups possessing a fair market valuation evaluated by a certified merchant valuer.
How to claim angel tax exemption?
To be eligible for startup tax exemption as per Section 56(2)(viib), you should the below-mentioned steps:
Step 1: Establish Your Startup India Account
You need to visit the startup India portal, construct your user profile and attain recognition from DPIIT. It’s important to secure DPIIT recognition as it’s a prerequisite for availing startup tax exemptions.
Step 2: Submit the Application
Once you’ve obtained DPIIT recognition, the subsequent step involves completing Form – 56. This form function as a “Statement from a Startup for seeking exemption as per Section 56 (2) (viib) of the Income Tax Act, 1961.” When completing this form, you will need to provide the subsequent information:
- Startup Name
- Date of Incorporation
- Incorporation/Registration Number
- Business Address
- Nature of Business
- Startup’s Contact Information (Phone number, email address, and PAN)
- DPIIT Recognition Number
Step 3: Submission of Declaration Form
As part of the process to apply for angel tax exemption, a startup is required to submit a declaration to the relevant authorities. As outlined in the official communication dated 19th February 2019 from the government, the startup must declare that, for a span of 7 years, it will avoid their involvement in the following activities:
- Investing in residential properties not intended for business purposes by the startup.
- Acquiring land or buildings, or both, except for those directly utilized by the startup for its business operations.
- Extending loans or advances beyond the regular business course, excluding cases where lending money forms a significant portion of the startup’s operations.
- Providing capital contributions to external entities.
- Dealing in shares and securities.
- Procuring high-value assets such as motor vehicles, aircraft, yachts, or other means of transport with a cost exceeding ten lakh rupees, unless they are meant for business purposes like hiring, leasing, or trading.
- Holding jewelry, unless it serves as inventory for the startup’s regular business activities.
The declaration document should be printed on the startup’s official letterhead and appropriately validate by the authorized representative of the company.
Step 4: Evaluation by an Officer
Each application seeking angel tax exemption as per section 56(2)(viib) of the Income Tax Act is assigned to an assessment officer. This officer meticulously reviews all the documents submitted by the startup and cross-checks the provided information against the declaration. Based on their discretion, the officer then issues either an order or a certificate granting tax exemption to the startup. If, even after the assessment, any false information is discovered in the declaration, the officer retains the authority to revoke the granted angel tax exemption.
Consequences of Rule Violation for Angel Tax Exemption
Startups that inaccurately report their income during the angel tax exemption application process will face penalties. In such instances of income under-reporting, the penalty incurred amounts to 200% of the tax payable on the underreported income. This underscores the importance of accuracy when seeking the benefits of this tax exemption for startups. For reliable and precise information about your business, you can tap into the expertise of LegalWiz.in’s team of Chartered Accountants.
Additional Tax Advantages for Indian Startups
Beyond the angel tax exemption, certain startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) can also enjoy a 100% tax deduction for three consecutive years. This tax incentive, outlined in section 80 IAC of the Income Tax Act, is commonly referred to as the Section 80 IAC tax benefit designed to bolster startups.
Conclusion
So far, only wealthy individuals who are residents, commonly known as Angel Investors, were subject to section 56 (2) (viib), which refers to the ‘angel tax’. However, the Finance Act of 2023 introduces a new provision that extends the scope of angel tax to include non-resident investors in closely held unlisted companies. This means that starting from the assessment year 2024-25, foreign individuals investing in Indian startups will also be liable to pay angel tax. This change underscores the importance of the angel tax exemption that is currently granted to startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) in India.
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