Update on Angel Tax Exemption for Startups
After claims being made by several start-ups that they are receiving tax notices under Section 56(2) (viib) of the Income Tax Act, 1961, to pay taxes on angel funds received by them, the Department for Promotion of Industry and Internal Trade (DPIIT) in consultations with CBDT resolved the issue. To mitigate genuine difficulties of start-ups and investors, in Budget 2019 speech by Finance Minister Nirmala Sitharaman, it was announced that "to resolve the issue of angel tax, start-ups and their investors who file requisite declarations and provide information of their returns will not be subjected to any kind of scrutiny."
Section 56(2) (viib) of the IT Act provides that the amount raised by a Private Limited Company in excess of its fair market value would be deemed as income from other sources and would be taxed at the normal rate of tax. Touted as an anti-abuse measure, this section was introduced in 2012. It is dubbed as angel tax due to its impact on investments made by angel investors in start-up ventures.
To claim exemption from Angel tax for any Private Limited Company who is planning to raise funds at a premium in the future, an application for Start-up Recognition is to be made to DPIIT and the details are available at https://www.ayta.in/post/start-up-india-registration.
It is to be appreciated that Government has recently widened the definition of Start-ups to include within its ambit any Private Limited Company who is having scalable business model and can either generate employment for the society or can create wealth for its shareholders and hence innovation per se is not required to prove the activities as Start-up and there are many other benefits available to Start-ups.
About Angel Tax
Section 56(2) (viib) of the Income-tax Act, 1961 (Act) provides that where a closely held company issues shares to a resident, for the amount received in excess of the fair market value of the shares, it will be deemed to be the income of the company under the head "income from other sources".
Section 56(2) (viib) is an anti-abuse provision drafted to overcome the dumping of cash funds in otherwise less valued private companies by any resident taxpayer. Where the sale consideration received by a private company exceeds the Fair Market Value ('FMV') of such company, a tax (is imposed on the difference between the two, taxed in the hands of the receiver-private company. The FMV of such private company is required to be computed in accordance with valuation rule 11UA (2).
The Rule 11UA(2) provides two methods of valuation, i.e., Net Asset Value Method and the fair market value determined by the merchant banker as per the Discounted Free Cash Flow method. Earlier, the Chartered Accountant was also allowed to determine the FMV using the Discounted Free Cash Flow method. However, after the amendment by the Income-tax (Sixth Amendment) Rules, 2018, w.e.f. 24-5-2018, only a merchant banker can determine the FMV.
There is no authentic record to show how this tax acquired this name in common parlance. With the rationale of ensuring that the excessive amount received as share premium does not escape taxation in the guise of accommodation entry and also, to prevent generation and circulation of unaccounted money, the objective behind introduction of this section was noble.
Brought in with fair intention, the section sought to introduce itself as a "measure to prevent generation and circulation of unaccounted money". However, the section had a far-reaching impact, adversely affecting the genuine companies as well. Since this section did not provide any basis or means of distinguishing the bonafide from the malafide, a contra-effect was observed by the start-ups, which, even as on date, places an excessive reliance on the funding received from liquidating the share capital.
It is essential to state that the start-ups commanded a huge premium over its fair value, owing to the intangible ideas, patents, trademarks, etc, further clubbed with the prospective sales and growth potential in the business models of the start-ups. The receipt of this premium was against the provisions of Sec 56(2)(viib), hence, the start-ups were the most affected by this section. Since the funding received by the start-ups was known as "Angel Investment", the tax charged with the introduction of this section came to be known as "Angel Tax".
If you wish to know more or have any queries related to Angel tax exemption, feel free to get in touch.
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