This article is written by Yogita, BA-LLB,MVN University, Palwal during her internship at LeDroit India.
Abstract
The Angel Tax: Ten years of controversy, and how it is about to be removed in India This critical assessment considers the Angel Tax which is otherwise known as Section 56(2) (viib) of Indian Income tax Act, 1961 enacted in 2012 as a means of limiting the amount of money laundering that occurred due to overvaluation of share issues over excessive issuance. Although its intention was to promote startup capital, to some extent, it negatively affected the true startups and caused a lot of tension and conflict on valuation interpretations. This was all because of the definition of Fair Market Value (FMV) statement. Old companies still had a chance to remain conservative, but young startups, which received valuation based on untangible resources and future promise, found it difficult to fit in the strict approaches to taxation. This tax that was levied at about 30.9 percent of any premium received, in excess of the FMV, deterred angel investing, introduced an element of uncertainty and produced cumbersome adherence and examination over valuation. The Angel Tax had a major adverse impact on fundraising by startups, by decreasing the level of aspiration by angels, as well as raising due diligence and legal expenses, and by requiring complex transaction structuring. Foreign Direct Investment (FDI) was also questioned as Finance Act, 2023 was extended to the non-resident investors. The focus of founders on growth was frequently shifted to conformity and might have resulted in the erosion in the valuation of the early stage. The primary basis of litigation was the valuation methods annunciated by the Income Tax Rules especially the Discounted Cash Flow (DCF) Method and the Net Asset Value (NAV) Method. BCA that handled the tax also regularly disapproved DCF valuation in favor of NAV and this led to increased tax claims.Critical case laws including ITO vs. M/s Vaatsalya Healthcare & Allied Services Pvt. Ltd. and Gaurav Goel vs. Income Tax Officer have been providing very important precedents by deciding that DCF valuations professionally done by proper assumptions at the time of valuation cannot be invalidated later only because of the results, and are allowed at the time of valuation. Such decisions highlighted the significance of bank valuations by merchant bankers and placed burden of proving to the revenue that there was an imperfection in valuation.
Introduction
Section 56 (2) (viib) of the Income-tax Act, 1961 (popularly called the Angel Tax) has been a double pointer of contention and a major cause of concern to the Indian startup ecosystem in the last decade.Although its stated aim was to reduce money laundering and black money transmissions via overpriced share issues, its actual consequence was corporate level start-ups to unwarranted taxes and years of work to recover losses on protracted court battles on court priced issues.Hence, in this overall review, we will go to the depth of understanding angel tax, effects on startup capital raising, and demonstrate it with case laws related, and also in relation to its current abolition proposals.
History and Development of Angel Tax: What is it?
Anti-Abuse Angel Tax was implemented in 2012. It provided that where a company engaged in business (without being listed in a stock exchange) or holding company sold shares to a resident investor at a higher price than its Fair Market Value (FMV), then, the amount in excess would be considered as income of the company under the head of income of other sources and would be taxed at a rate of about 30.9 per cent. Its working hypothetical is that, any extra amount collected above FMV could well be untraceable funds that are laundered to get into genuine system. The concept of the fair market value remained the issue. In case of well established and with an evident revenue stream and predictable profits, a valuation method such as Discounted Cash Flow (DCF) or Net Asset Value (NAV) could therefore be easily used. Nevertheless, the situations in which startups, at their initial stage of development, tend to work on a base of ideas, future prospects, and the absence of material assets, generating no profit, or are much more restricted: negligible.Valuation is necessarily prospective and speculative, and it is difficult to be flexible with strict valuation regimes designed by taxation bodies.
Primordial Struggles and Rejection
Angel tax attracted an instant outcry among startup entrepreneurs, investors and industry associations.
Dissuasion of Angel Investments: Angel investors, who are important source of early stage capital, became conservative as they feared their money could be charged with this tax. This hit the lifeline of young start-ups hard.
Valuation Challenges and Review: Startups were then hit with the long and costly process of tax litigation when taxpayers did not accept the valuation generally claiming that the value of shares was publicized. The tax officers who are not expert in startup valuation used the usual practices that were not applicable in start-up firms.
Uncertainty and Compliance Cost: The confusion that existed with respect to determining FMV and the fear of retroactive tax collection caused uncertainty, which made founders spend their time and resources towards business development that was spent on tax notices.
Influence on Bona Fide Fundraises: Even the bona fide fundraising rounds, which are generally based on how investors felt about the future potential of a startup, were perused, and the gap between the institutional tax department FMV and the actual issue price was taxed.
Effect on Startup Fundraising
The angel tax had major effect in deteriorating the Indian startup fundraising environment as follows:
Weaker Investor Demand: Investors especially angel investors and early-stage venture capitalists shied away of investing in Indian companies because there was a possibility of tax liability on the companies they invested in. This diminished the financing capabilities of creative undertaking. More Due Diligence and Legal Fees: The startups and investors were forced to spend time in due diligence to support valuations, most times involving merchant bankers and lawyers, thus the high cost of transactions. Complex Structuring of
Transactions: To avoid angel tax, startups and investors adopted a complex structuring of investment rounds, which increased both legal and advisory costs, as well as in certain cases the less desirable terms towards the founders.
Deterrence to Foreign Investment (Post-2023 Amendment): Originally, angel tax was majorly imposed on resident investors.
Yet, it was also applicable to the non-resident investors, as it was extended in the Finance Act, 2023, so the interests in its consequences towards foreign direct investment (FDI) into Indian start-ups were also raised. Although this action was believed to balance out the playing field, it was perceived that this act may drive away important foreign funding, which is a major source of venture capital to grow Indian startups on. Change of Emphasis –
Growth to Compliance: The founders, instead of spending their precious time and resources on the development of their products, expansion of their markets, and staff addition had to spend the same on collecting tax receipts, defending themselves in hearings, and disputing assessments. This took away entrepreneurial forces that were focusing on innovation and growth.
Dilution at Early-stage Valuations: This perhaps has motivated the startups to offer lower valuation than they are otherwise entitled to, simply to avert the angel tax issue, which results in an exaggerated dilution of equity among the founders at early stages.
The Valuation Puzzle
The Income Tax Rule, especially Rule 11UA is the rule in determining the FMV of a unquoted shares. These mostly were:
Discounted Cash Flow (DCF) Method: This model forecasts the future cash flows of any company and calculates them to the actual current value. Although in theory, a reasonable way to value future potential, it depends too much on assumptions, which tax authorities frequently opposed.
Net Asset Value (NAV) Method: This is the method that values the company by the difference between the assets of a company and its liabilities. It should best fit to those mature companies with heavy assets, but is not very relevant to early-stage, asset-light startups. The DCF approach adopted by startups was often neglected by tax authorities on the ground of impractical projections and the NAV approach was used, which always led to a FMV that is lower and a higher excess premium that is taxed under section 56(2) (viib).
Illustrative case laws.
As the landscape is changing considerably due to the recent abrogation, it becomes possible to draw an idea of the challenges that startups face by associating them with the judicial pronouncements.
Gaurav Goel Vs. Income Tax Officer (ITAT Delhi): Facts: Just like Vaatsalya, this case concerned the rejection of DCF valuation by tax authorities and use of NAV method.The tax department claimed that the startup projections were pushy. The Manual decision: The ITAT, Delhi bench, repeated the rules governing in Vaatsalya. It stressed that it is upon the Assessing Officer to prove that the DCF valuation report is fundamentally calamitous or grounds its calculation on irrational pastimes as opposed to its replacement with some other mode. What matters on the validity of the valuation at the time of fundraising is not the performance of the company in the years that shall follow, emphasized the Tribunal.
Impact: The case further entrenched the position of the tribunals towards the view that DCF valuations should always be admitted in cases it was prepared carefully and on sensible assumptions at the time of valuation giving some clarity to startups.
Innoviti Payment Solutions Pvt. Ltd. and A.O. (Assistant Commissioner of Income Tax) vs. Bangalore ITA:
This was the case regarding the use of angel tax on convertible instruments. The authorities attempted to use the conversion of Optionally Convertible Preference Shares (OCPS) to equity shares with premium as the provisions of Section 56(2) (viib) of the Taxation Act, 1984.
Held: ITAT ruled that Section 56(2)(viib) has to be applied on issue of shares rather than the conversion. The premium was paid when the OCPS was subscribed to and in the event that the transaction was not accompanied by angel tax then, the conversion should not be so.
Effect: This redefined the applicability of angel tax to various instruments of raising funds, and these could not be used retroactively on conversions.
Litigation Key learnings:
Validity of Merchant banker Valuations: Validity of valuations carried out by independent merchant bankers was always upheld by the courts so long as the method and reasonable assumptions adopted were prescribed.
Hindsight does not Count: The performance a company hits in future years cannot be used by tax officials to make void a valuation made during fundraising.
Burden of Proof on Income Tax: The burden was cast on the tax department to come forward and demonstrate that the valuation that had been taken by the startup was not reasonable or faulty, simply so as to replace it with what they would prefer.
Place the Emphasis on the Why: Startups had to be able to give a clear statement with the documentation of the rationale of their valuations to include growth projections, market opportunities, and the competitive advantages in defending themselves against the effects of tax scrutiny.
Current Updates : Angel Tax was abolished
Finance Minister Nirmala Sitharaman, in a big step to inject momentum into the Indian startup industry, in the Union Budget 2024-25, proposed that the angel tax be removed on all categories of investors, with effect from Financial Year (i.e., 1 April 2025) 2025-26. This move has been largely acclaimed as a ground-breaking change and in response to a long-time demand by start up community.
After-effects of Abolition: Restored Investor Self Confidence: Angel investors at home and abroad should get a new shot of confidence after the abolition, all threatened by the possibility of tax requisition in the event of valuation disagreement. This may result in better inflow of the seed capital into the Indian start ups.
Lessened Compliance Burden: Startups will not be wasting considerable time and resources in covering their backs against tax inquiry on their valuation provisions, and can concentrate on their line of business.
EasyFund raising: The process of fundraising should also be easier and more effective, by doing away with the extra concern of angel tax and possibilities of litigation.
Increased Global Competitiveness: Such removal of this regulatory barrier would make the Indian startup environment more appealing to foreign investors and entrepreneurs leading to it being ranked as a competitive center of innovation.
Prioritization of Innovation and Expansion: The transfer is part of the government strategy to have a robust and friendly environment regarding innovation, entrepreneurship and employment.
Conclusion
The Angel Tax, which seems to have been first envisaged as an eminent cause, to avert monetary illicit financial outflows, placed unsolicited barriers in the way of authentic growth of the Indian startup ecosystem. It compelled founders to engage in a years-long valuation war, scared off the essential seed funding and made entrepreneurs work on the tax regulations instead of building businesses.Although the judicial pronouncements provided some relief as they stressed upon the validity of recognized professionally conducted valuations and limitile arbitrary replacement of means by tax administrations, the underlying problem posed a problem of confusion and difficulty. Proposed to be abolished on angel tax on all types of investors, effective on FY 2025-26, this is a breaking point. It represents an active and sympathetic stance of the government to the peculiarities of startup valuations and the essentiality of angelic investments in drive the innovation. The action is likely to release substantial capital, lower compliance costs, and make the environment more favorable to the growth of Indian startups, which will capture local and foreign investments and eventually make India a global startup player. The future also looks more promising to Indian entrepreneurs because now they would be able to concentrate more on their businesses and not on the angel originally leading to unexpected tax liability.
Reference
https://indiankanoon.org/doc/195265891
https://www.casemine.com/judgement/in/56095ff3e4b01497112cb880/amp
