Angel tax axe opens funds-gate for startups

In a move that will widen the pool of available capital for startups and expedite closure of funding rounds, angel tax for all classes of investors has been axed. "This will make it significantly easier for us to complete transactions faster and streamline the investment process. Previously, the requirement for IT officers to understand and assess valuations led to unnecessary conflicts and delays. Valuation assessments were never meant to fall within the purview of IT officers. This change eliminates those complications," said Anirudh A Damani, managing partner, Artha Venture Fund.

Investors, who had earlier been reluctant to fund companies amid fears that a big part of their funding would get taxed, will now be more forthcoming in betting on early-stage startups, said Arpit Chug, CFO at Razorpay. The number of active domestic investors is expected to jump 10-20% as a result of this policy change, said Kulmani Rana, founder of startup accelerator Fibonnaci Global. An angel tax at 30.6% was levied when an unlisted company issued shares at a price higher than its fair market value.

Introduced in 2012 as a measure to prevent generation and circulation of unaccounted money, the scope of the angel tax which initially had applied only to investments from early stage investors like high net worth investors and family offices was in budget 2023 expanded to cover foreign investors, dealing a body blow to the ecosystem which is heavily dependent on foreign funding, particularly in the growth and late stages. Section 56(2)(viib) of the Income Tax Act or angel tax sought to tax the difference between the issue price of securities by an unlisted company and its fair market value when such shares are issued to investors. “Startups who raised capital would get tax notices asking them to justify their valuations against actual performance. If the divergence of the projections in the valuation report and actual performance was high, the tax officer would dismiss the valuation report and tax all the share premium as income,” Siddarth Pai, founding partner at 3one4 Capital had said in an earlier note.

Startup valuations are largely based on the company's future potential. "Beyond the potential constraints on cash flow, the angel tax created numerous challenges during fundraising efforts, which worsened last year when even foreign investments became subject to this tax," said Anisha Patnaik, angel investor and founder, LexStart Partners.

Startups and investors have for long been pitching for the removal of angel tax which hurt operations of smaller startups, some of which had to even shut shops in the past weighed by tax liabilities.

Smita Goel, director, tax and compliance at VC firm RTP Global said that the move will speed up the fundraising process for companies looking to raise capital. Besides, it should help the firms (served with angel tax notices) to be able to close their tax demands faster. “A lot of cash that was getting blocked for this will also get freed up,” Goel said.

“By abolishing angel tax, the government has given a major fillip to the startup ecosystem, fostering more investments, growth, and innovation in India, and enhancing its capabilities to cater to global demands. Additionally, the reduction of capital gains tax for unlisted equity aligns it with listed equity is another strong move, further boosting investor confidence and liquidity in the startup space,” added Mayank Kumar, Co-founder and MD at upGrad.

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