The Indian government has abolished the angel tax, formally known as Section 56(2)(viib) of the Income Tax Act, to bolster the startup ecosystem and encourage innovation.

Summary:

In a bid to enhance the startup ecosystem and promote innovation in India, Finance Minister Nirmala Sitharaman announced the removal of the angel tax. The angel tax, introduced in 2012 under Section 56(2)(viib) of the Income Tax Act, imposed a tax on premiums paid by investors above the fair market value of shares in unlisted companies. This tax aimed to curb money laundering but was criticized for hindering investment and innovation.In a significant move to bolster the startup ecosystem and drive innovation in India, Finance Minister Nirmala Sitharaman announced on Tuesday the scrapping of the contentious angel tax. This decision, part of the government’s ongoing efforts to create a more conducive environment for startups, underscores the commitment to supporting new businesses and fostering economic growth.

The Angel Tax: An Overview

The angel tax, formally known as Section 56(2)(viib) of the Income Tax Act (ITA), was introduced in 2012. It targeted investments made by unlisted companies through the issuance of shares, imposing a tax on any premium paid by investors above the fair market value of the shares. This premium was classified as “income from other sources” and subjected to taxation.

Originally, the Finance Act of 2012 added this provision to address concerns related to money laundering and the flow of unaccounted funds. However, the tax quickly became a point of contention among startups and investors, who argued it was a significant barrier to innovation and fundraising.

Challenges and Criticisms

Several key issues plagued the angel tax:

Valuation of Shares: Startups often found it challenging to justify their share valuations under the tax provision.
DCF Method: The treatment of estimated figures in the discounted cash flow (DCF) method led to disputes.
Funding Scrutiny: The tax led to intense scrutiny of funding sources and investor credibility.
Retrospective Application: The retrospective nature of the tax affected the conversion of convertible instruments into equity.

These issues collectively contributed to a challenging investment climate, prompting calls for reform from the startup community.

Positive Reception from Industry Experts

The decision to abolish the angel tax has been well-received by industry experts and stakeholders. Rahul Charkha, Partner at Economic Laws Practice, hailed the move as a significant step towards providing clarity and avoiding unintended negative consequences on foreign investments. “This decision is a welcome step towards providing tax certainty, preventing unintended consequences on foreign investments, and supporting startups,” Charkha noted.

Similarly, Ankur Mittal, Co-founder of Inflection Point Ventures, emphasized the potential regulatory clarity this decision brings. “This action has the ability to bring a lot of regulatory clarity, which is generally appreciated by the investor communities across the world. This should help founders looking to raise capital both in domestic and international markets,” Mittal said.

Government’s Continued Support for Startups

Earlier this year, in the interim budget presented in February, the government proposed extending tax incentives for startups and investments backed by sovereign wealth or pension funds until March 2025. This step aimed to provide more time for these investments to benefit from tax relief and further support the startup ecosystem.

With the scrapping of the angel tax, the government aims to create a more favorable atmosphere for innovation and investment in India. This move is expected to ease the fundraising process for startups, making the country an attractive destination for both domestic and international investors.