The Indian startup ecosystem has flourished over the last decade, but with growth comes regulatory scrutiny. One significant tax provision that startups need to be mindful of is the Angel Tax under Section 56(2)(viib) of the Income Tax Act, introduced by the Finance Act, 2012, applicable from Assessment Year 2013-14. This provision was designed to prevent money laundering through inflated share valuations, but it has also impacted legitimate startups raising funds at a premium. Let’s dive into the details of this provision, including its applicability, exemptions, and the latest amendments to support the startup community.
What is Angel Tax Under Section 56(2)(viib)?
The Angel Tax provision under Section 56(2)(viib) applies when a closely-held company (a company in which the public is not substantially interested) issues shares to an investor at a price higher than the Fair Market Value (FMV) of those shares. The difference between the FMV and the price paid by the investor is treated as “Income from Other Sources” and taxed accordingly.
This tax was introduced to curb tax avoidance schemes, wherein companies would issue shares at a significant premium to undisclosed or unexplained investors, often with the intent of laundering black money.
Conditions for Applicability of Section 56(2)(viib)
For this provision to apply, the following conditions must be cumulatively satisfied:
- Recipient: The recipient of the investment must be a company.
- Type of Company: The company should be a closely-held company (i.e., a company in which the public is not substantially interested).
- Nature of Receipt: The company must receive consideration for the issue of shares.
- Consideration Exceeds FMV: The consideration received for the shares must exceed the fair market value of the issued shares.
- Assessment Year: This provision applies to any previous year starting from 2012-13.
- Resident Investor: Up until the Assessment Year 2023-24, the provision applied only if the consideration was received from a resident person.
Fair Market Value Determination Methods
The Fair Market Value (FMV) of shares is critical in determining the applicability of Section 56(2)(viib). The FMV can be determined using the following methods:
- Net Asset Value (NAV) Method: As per Rule 11UA(2) of the Income Tax Rules, this is based on the book value of assets and liabilities.
- Discounted Cash Flow (DCF) Method: The valuation is done based on projected cash flows of the company, determined by a merchant banker.
- Company-Substantiated Valuation: The company can justify a higher FMV based on the value of its tangible or intangible assets (goodwill, patents, trademarks, etc.).
Note: Assessing officers (AO) are empowered to determine the FMV of shares before invoking Section 56(2)(viib). In cases where the AO disagrees with the company’s valuation, courts have ruled that minor discrepancies should not result in reassessments, as seen in CIT v. Vaani Estates (P.) Ltd. (2020) and CIT v. VVA Hotels (P.) Ltd. (2020).
Exemptions from Angel Tax: DPIIT Recognized Startups
To promote entrepreneurship and innovation, the government has provided several exemptions from Angel Tax, particularly for startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT). These exemptions are vital to ensure that startups can raise funds without fear of tax complications.
Startups Recognized by DPIIT
A startup can be exempted from Angel Tax if it meets the following conditions:
- DPIIT Recognition: The startup must be recognized by the DPIIT.
- Paid-Up Capital and Premium: The startup’s aggregate paid-up share capital and share premium should not exceed ₹25 crore after the issuance of shares.
- No Investment in Specified Assets: The startup should not invest in certain assets, such as:
- Land or buildings not used for business purposes.
- Motor vehicles with an actual cost exceeding ₹10 lakh.
- Capital contributions to other entities.
- Shares, securities, and other non-business assets.
Additionally, any investment in these assets must be avoided for seven years from the end of the latest financial year in which shares were issued at a premium.
Non-Applicability of Section 56(2)(viib) in Specific Cases
The Angel Tax provision will not apply if the consideration for the issuance of shares is received by the company from:
- A Venture Capital Company or Venture Capital Fund as defined under Section 10(23FB).
- A Specified Fund such as a Category I or II Alternative Investment Fund (AIF), regulated by the SEBI (AIF) Regulations, 2012.
Additionally, companies that meet the conditions specified in the Notification No. GSR 127(E), dated 19-2-2019, issued by the DPIIT, can also seek exemption from this provision.
Clarifications and Circulars on Assessment of Startups
To provide clarity on the application of Section 56(2)(viib), the CBDT issued Circular No. 16/2019 and Circular No. 22/2019. These circulars outline the following procedures:
- Limited Scrutiny Cases: If a startup is recognized by DPIIT and selected for scrutiny solely on the issue of applicability of Section 56(2)(viib), the Assessing Officer (AO) must accept the startup’s contention without further verification.
- Multiple Issues Scrutiny: In cases where multiple issues are under scrutiny, the AO must seek approval from the supervisory officer before pursuing the Angel Tax issue.
- Startups Without DPIIT Recognition: If a startup is not recognized by DPIIT, the scrutiny process continues as per normal procedures but requires supervisory approval.
Important Case Laws on Angel Tax
Several judgments have shed light on the application of Section 56(2)(viib):
- CIT v. Vaani Estates (P.) Ltd. (2020): It was ruled that the FMV of shares must be determined before applying Section 56(2)(viib).
- CIT v. Sunrise Academy of Medical Specialities (India) (P.) Ltd. (2018): This judgment clarified that Section 56(2)(viib) takes precedence over Section 68 (unexplained credits).
Impact of Angel Tax on Startups
The Angel Tax provision has been a point of concern for startups, especially those raising funds at a premium. The fear of being taxed on the difference between the FMV and the share price has often deterred investments. However, with the exemptions provided for DPIIT-recognized startups, the situation has improved significantly.
By fulfilling the necessary conditions for DPIIT recognition, startups can benefit from Angel Tax exemptions, enabling them to focus on scaling their businesses without the burden of unnecessary tax scrutiny.
FAQs
1. What is Angel Tax under Section 56(2)(viib)?
Angel Tax refers to the tax levied on the difference between the fair market value (FMV) of shares and the price at which a closely-held company issues those shares to investors.
2. How can a startup avoid Angel Tax?
A startup can avoid Angel Tax if it is recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) and meets the specified conditions regarding share premium, paid-up capital, and investment restrictions.
3. Does Angel Tax apply to all types of companies?
No, it applies only to closely-held companies where the public is not substantially interested.
4. What is the FMV, and how is it determined?
The Fair Market Value (FMV) of shares can be determined using the Net Asset Value (NAV) method, the Discounted Cash Flow (DCF) method, or based on the value of the company’s assets.
Conclusion
The Angel Tax provision under Section 56(2)(viib) of the Income Tax Act is designed to prevent tax evasion through inflated share premiums but can pose challenges for startups raising legitimate funds. However, the government has introduced exemptions for DPIIT-recognized startups, allowing them to raise funds without being subjected to Angel Tax, provided they meet certain conditions.
As a startup, it is crucial to understand the provisions of Section 56(2)(viib) and seek DPIIT recognition to avoid tax complications while raising capital. For more information on the process of DPIIT recognition or tax implications for startups, feel free to explore our resources at SmartTaxSaver.com.
