Budget scraps controversial angel tax, eases burden on startups

Angel tax is a term used when companies raise capital at a premium above their fair market value. (Representational image)

Firstly, I’m pleased to see the decade-old contentious issue of angel tax being completely scrapped. To provide some background, it was originally introduced in 2012 when Pranab Mukherjee, as Finance Minister, first introduced the tax. Despite revisions and concessions, it has continued to pose a major challenge for founders.

The tax has been troublesome not only for startup founders and companies but also for angel investors. Its removal is a very welcome move because the prevailing regime was widely acknowledged as incorrect and unfair, yet nothing was effectively done about it.

To this day, it has led to numerous instances of harassment and tax-related stress for both founders and angel investors. I personally know several domestic angel investors who had ceased investing due to their reluctance to engage in this debate. After three or four years of investment, they would receive notices demanding taxes, along with questions about the source of funds and income tax returns.

Additionally, companies and founders had to furnish documents relating to their investors. In some cases, companies themselves were forced to shut down, despite investors losing their money, due to tax officials sending notices to pay angel tax.

One crucial point to note is that the amount of investment, especially in terms of significant sums, typically comes from foreign institutional investors rather than angels. Therefore, while the quantum of investments may not see much change, early-stage startups reliant on pure angel investments—though fewer in quantum—stand to benefit substantially.

Industry’s Grouse with Angel Tax

The industry’s struggle with angel tax was profound. The issue primarily involved harassment and arbitrary interpretations by income tax authorities concerning startup valuations. Angel tax is a term used when companies raise capital at a premium above their fair market value.

Now, in such a scenario, it becomes a major harassment tool in the hands of income tax. They can dispute any valuation. Take the example of Byju’s. If you say Byju’s was valued at $22 billion, now it's valued at $1 billion. Therefore, the fair market value should have been $ 1Bn. If you raised, say $ 1 Bn of capital, then 30 % of the money raised is taxed as supposed the Fair Market value is fraction of the actual valuation.

Nobody has gained money. Nobody has made a profit.

The company has not made an income, it has only received investment. And officials are asking them to pay 30 % of the excess difference as tax.

Determining fair market value is subjective and not an exact science. Valuations can vary widely among investors and even industry experts. This subjectivity made it a tool for harassment by tax authorities, who could dispute valuations at their discretion. For instance, a company valued at $22 billion one day might later be valued at $1 billion, drastically affecting the supposed fair market value and tax liabilities.

This practice was purely arbitrary and a means of harassment. There were cases where startups, already struggling, received retrospective notices demanding taxes on investments that were not profits but merely capital infusions.

While there were exemptions for DPIIT-registered startups, obtaining DPIIT registration was cumbersome and not all startups qualified. This complexity turned into a nightmare for the entire Indian startup community.

For example, if I want to take an undue consideration of somebody, I can actually create a startup, value it at a very high value, and ask you to invest, say for 1% stake and get Rs 1 crore into my startup for 1% stake as a way to get 1 crore. Otherwise, there is no way for me to get 1 crore legally.

Here’s another example, the paid-up capital or share premium should be less than 10 crores. A minimum net worth of the investor should be 2 crores. The average income for the last three financial years should not be less than 50 lakhs.

In some extreme cases, tax authorities directly deducted income tax from startup bank accounts. The genesis of these measures was to prevent misuse of fundraising for illicit gains or money laundering, yet the implementation became burdensome and punitive for legitimate startups.

However, the removal of indexation benefits on property sales has been unexpectedly harsh, especially considering the substantial rise in property prices across most parts of the country. This change will increase the tax burden on individuals, despite potentially boosting government revenue.

On a positive note, the reduction of TDS from 1% to 0.1% in e-commerce transactions is a commendable move. TDS was a significant administrative burden, and this reduction is timely, given the expansion of e-commerce activities in the country.

Overall, I am very glad to see the complete elimination of angel tax.

Though, the removal of indexation benefits on sale of property has been quite surprising. Because property prices have run up substantially in most part of the country.

So, that will mean more income for the government, but it'll increase the tax burden for people. On the tax front, the e-commerce focus where the TDS has been cut down from 1% to 0.1% is a very good move. TDS was a pain, that has been substantially cut down to 0.1% and it is a welcome move, especially now, since you see expanding eCommerce transaction in the country.