1. Background

With the aim of fostering entrepreneurship and promoting innovation by creating an ecosystem that is conducive for growth of start-ups and to enable India to become a nation of job creators instead of a nation of job seekers, the Government of India launched the "Start-up India" initiative on 16th January 2016. Recognizing the importance of these start-ups, the Finance Minister in the Interim Budget, 2019 presented on 1st February, 2019 stated that, "With job seekers becoming job creators, India has become the world's second-largest start-up hub. We are proud of the hard work and innovative ideas of our youth."

What is Angel Tax?

To keep a check on the closely held companies from bringing in undisclosed income into the company by issuing the shares at abnormal premium, Section 56(2)(viib) was introduced into the Income Tax Act, 1961 by the Finance Act 2012. According to this, whenever a closely held company issues shares to resident investors at a price that is over and above the Fair Market Value (FMV), the amount received in excess of the FMV will be treated and chargeable to tax as Income from Other Sources. In order to arrive at the FMV, valuation methods were prescribed under the Income Tax Rules, and the certificate for the same is to be obtained from a Merchant Banker. This taxation provision was loosely called as 'angel tax'. Para 11(a) of SA 240 defines fraud as an intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage.

Start-up and Angel Tax

The Department for Promotion of Industry and Internal Trade (DPIIT) was entrusted with the responsibility to administer the Start-up India scheme. DPIIT issued various notifications which defined the word start-up and mentioned the procedure to obtain recognition as a start-up with DPIIT. As per those notifications, as applicable today, the entity, i.e., a Private Limited Company or a Registered Partnership Firm or an LLP shall be considered a start-up:

• Up to 10 years from the date of its incorporation/registration
• The turnover for any financial year does not exceed INR 100 crores
• It is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential for employment generation or wealth creation.

Tax Notifications and action taken by Tax Officers

Following the DPIIT notification, the Central Board of Direct Taxes (CBDT) issued a notification in 2016, exempting the 'start-ups' from angel tax that receive funding from angel investors/fund houses or any person resident in India, which satisfies all the above conditions. The tax officers, however, started invoking angel tax provisions in case of start-up by rejecting/modifying the valuation reports that they submitted. The tax officers chose to make such additions by alleging that subsequent actual revenues do not match up to the projections carried out in the valuation workings. Widespread representations were made against such a regressive approach adopted by the tax authorities. In response to that, CBDT brought out an instruction on 6th February, 2018 as to not take any coercive measures to recover the outstanding demand against these start-ups and directed that necessary administrative steps be taken for the cases that were pending before the Appellate authority for expeditious disposal.

To make the provisions more start-up friendly, DPIIT brought out another notification on 11th April, 2018 specifying conditions and procedures for seeking exemption from angel tax provisions. This, however, did not solve the problems that start-ups faced, as the tax authorities continued to make tax assessments in the same manner as earlier. This again was picked up by influencers on social media like Mr. Mohandas Pai and Mr. Anand Mahindra, who objected to this practice carried out by the tax authorities. This was responded to by Mr. Suresh Prabhu, Union Minister for Commerce and Industry, which prompted further amendments, which were made on 16th January, 2019 and subsequently all the earlier notifications were superseded by a fresh notification that was released on 19th February, 2019.

This notification puts the following conditions for a start-up company to be exempt from angel tax:

• Exemption from clutches of Section 56(2)(viib) [angel tax] shall be available if such company is a start-up as recognized by DPIIT based on the conditions mentioned earlier.
• The aggregate amount of the paid-up capital and the share premium after the proposed issue should not exceed INR 25 crores. In computing the threshold of INR 25 crores, the following is not counted:
• Shares issued to Non-residents or Venture Capital companies or funds, to whom the provisions of angel tax do not apply at all.
• Shares issued or proposed to be issued to companies whose shares are frequently traded on the stock exchange and whose net worth on the last day of the previous financial year exceeds INR 100 crores or turnover exceeds INR 250 crores.
• Such start-up has not invested in any of the following assets:
• Land or building or both unless it is used in the ordinary course of business.
• Loans and advances, other than loans in the ordinary course of its business where the start-up has lending as its substantial business activity.
• Capital contribution into another entity.
• Shares and securities.
• Any vehicle, aircraft or yacht whose actual cost exceeds INR 10 lakhs, unless it is a start-up in the business of selling, plying, hiring, or leasing of such vehicles.
• Jewelry, other than held as stock for its business.
• Other assets like drawings, paintings, archaeological collections, etc.

Also, no such investment is made by the start-up for a period of 7 years from the date of issue of shares at a premium, where the exemption from angel tax has been availed.

Conclusion

It was expected that this year’s budget will bring in more rationalization into the application of angel tax provisions. Since it was only an interim budget presented on 1st February 2019, no such amendments were proposed in this interim budget. Hopefully, a more conducive taxation regime will evolve in the future, which will help genuine start-ups raise funds without having to worry about angel tax. This, in turn, will help start-ups flourish further, spark more innovation, employment, and economic progress. However, it is also important to ensure that malpractices using the route of investment raise are also kept in check.

It is also a very welcome fact that the Government responded to the industry by bringing in modifications to the mode of implementation of angel tax by moving very swiftly. Further, it is also very important to note that the regime has moved from "Application seeking exemption from angel tax" to "Declaration", which means that there is a thrust on self-declaration for eligible start-ups to avail the exemption from angel tax.