How we got here – the genesis of the angel tax provision
In the 2012 Budget, the Government of India introduced Section 56(2)(viib) in the Income Tax Act, 1961 (“IT Act”). Through this provision, the Government imposed a tax on the issue of shares by a company, where such shares were issued at a price that was more than the “fair market value” (“FMV”), treating the difference between the issue price and the FMV as income from other sources. Such income was to be taxed at a rate up to 30%. Importantly, the income tax officers had the discretion to either accept or reject the FMV as arrived at by the assessee companies, based on the valuation reports that they had obtained, or to calculate a new FMV.
The stated intent of introducing such a provision was to target the practice of investing unaccounted money into shell companies using artificially high valuations of such companies. However, the biggest impact of this tax was felt by Indian start-ups as the income tax authorities had started issuing notices to start-ups that had received early stage investments (commonly referred to as “angel investments”) which were often based on high valuations. Such valuations were typically based on factors such as future growth potential, expansion plans, etc. This led to the moniker, “angel tax”, which was far from angelic. Moneycontrol.com reported on a “… survey done by LocalCircles and the Indian Private Equity & Venture Capital Association (“IVCA”), over 73% of startups that raised capital between Rs. 50 lakhs to Rs. 2 crores in India had received angel tax notices from the Income Tax Department till January, 2019…” Additionally, various start-up associations also petitioned the Government regarding the adverse impact of such notices, highlighting the negative economic consequences and business sentiment in the country’s start-up ecosystem.
In response, the Department for Promotion of Industry and Internet Trade (“DPIIT”, earlier known as the Department of Industrial Policy and Promotion) issued the below notifications between April 2018 and February 19, 2019, seeking to address the concerns raised by Indian start-ups.
- DPIIT notification dated April 11, 2018 (“April 2018 Notification”);
- DPIIT notification dated January 16, 2019 (“January 2019 Notification”); and
- DPIIT notification dated February 19, 2019 (“February 2019 Notification”).
April 2018 Notification
This notification provided that any start-up which had been recognized by the DPIIT had to make an application to the Central Board of Direct Taxes (“CBDT”) seeking exemption from angel tax, which would at its discretion, either accept or reject its application. Essentially, this required a two-step application process: (1) the start-up applies to the DPIIT for recognition, based on the eligibility criteria (explained below), and (2) apply to the CBDT for exemption from angel tax.
January 2019 Notification
The two step process provided in the April 2018 Notification was regarded as being time consuming and inefficient, particularly given the delays in CBDT disposing off exemption applications from start-ups. This was partially addressed in the January 2019 Notification, which aimed at speeding up this process, by imposing a 45-day time limit for the CBDT to respond to exemption applications received from start-ups. Additionally, it eased certain other aspects of the application process, by removing the requirement to submit a valuation report prepared by a merchant banker and only requiring submission of financial records for the last 3 years.
However, the key concern remained that the CBDT continued to wield the discretion to reject applications made by start-ups that were already recognized by the DPIIT, thereby continuing to be subject to the threat of angel tax notices in the future, which in turn was expected to stifle domestic angel investments in start-ups, which is a key source of funding for early stage start-ups.
February 2019 Notification
Given that the two previous notifications did not fully address the threat posed by angel tax, the IVCA formed a working group, which submitted recommendations to the Government to resolve this matter. It’s recommendations included redefining the eligibility conditions for recognition of start-ups by the DPIIT, providing an automatic exemption from angel tax to all start-ups that are recognized by the DPIIT and increasing the angel tax exemption limit for consideration received up to Rs. 25 crores of paid-up share capital.
In response to these recommendations, the DPIIT published the February 2019 Notification. Some of the key highlights are as follows:
- Recognition of a Start-up
A start-up that satisfies the following conditions can apply to the DPIIT for recognition by making an online application. We have indicated the changes (if any) made to the April 2018 and January 2019 Notifications in brackets.
- It is a private limited company registered under the Companies Act, 2013 or a partnership firm registered under the Partnership Act, 1932 or a limited liability partnership registered under the Limited Liability Partnership Act, 2008;
- It shall be considered as a “start-up” up to a period of 10 years from its incorporation (earlier limited to 7 years from incorporation );
- The turnover of the entity for any financial year since incorporation does not exceed Rs. 100 crores (earlier limited to Rs. 25 crores); and
- The entity is engaged in an “eligible business” i.e. 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 of employment generation or wealth creation;
The DPIIT, on a review of the application, may either accept or reject the application.
- Exemption from Angel Tax
The February 2019 Notification, improving upon the April and January 2019 Notifications clearly sets out the eligibility criteria for start-ups to claim exemption from angel tax. Of utmost significance is that the CBDT no longer has discretion to reject an application for exemption. We have indicated the changes (if any) made to the April 2018 and January 2019 Notifications in brackets.
- The start-up is recognized by the DPIIT;
- Its paid-up share capital, after the proposed issuance of shares, does not exceed Rs. 25 crores. For calculating the paid-up capital for this criteria the following amounts are excluded: amounts received from any non-resident, a venture capital fund, a venture capital company and category I alternate investment funds registered with the Securities Exchange Board of India (earlier limited to Rs. 10 crores and did not provide for any exclusions); and
- The start-up has submitted a declaration in the prescribed form that it has not and will not utilize the proceeds received from such investment for the acquisition of prohibited assets as specified in the February 2019 Notification for a period of 7 years from the end of the latest financial year in which the shares were issued at a premium (unless such assets form part of their ordinary course of business). The list of prohibited assets includes land and buildings, loans and advances, shares and securities, jewellery and capital contribution to another entity. Note that if a start-up violates this declaration and invests in a prohibited asset, the exemption from angel tax may be revoked with retrospective effect (earlier, there was no such restriction on use of proceeds).
- Application for claiming deductions under the Income Tax Act, 1961
Section 80-IAC of the IT Act provides for an “eligible start-up” to claim a deduction of 100% of its profits from an “eligible business”, subject to satisfying the below conditions:
- It is a company or limited liability partnership incorporated between April 1, 2016 and April 1, 2021;
- Its turnover in the previous year does not exceed Rs. 25 crores; and
- It has obtained a certificate of “eligible business” from the Inter-Ministerial Board of Certification (the “Board”) consisting of the Joint Sectary of the DPIIT and one representative from the Department of Biotechnology and from the Department of Science and Technology which will either accept or reject the application. The February 2019 Notification now provides the form in which such application can be made to the Board. Once obtained, a certificate could be revoked, if it is determined that the applicant provided false information in the application. Note that only a private limited company or a limited liability partnership is eligible to claim the income tax benefits under this provision, thereby excluding start-up entities that are registered as partnerships.
Our thoughts on the implications of the February 2019 Notification
The Plus Points: We believe that the February 2019 Notification is a step in the right direction, and will certainly go some way in addressing the long-standing concerns of investors and start-ups in India, on account of the following reasons.
- The removal of CBDT’s discretionary power to determine FMV or reject applications for exemption from angel tax will be most welcomed, thereby reducing the threat of tax notices.
- News reports suggest that over 15,000 start-ups have been recognized by the DPIIT since the launch of the Start-Up India Initiative by the Government in January 2016. With the expansion of the definition of “start-up”, it is expected that the number of start-ups seeking recognition will significantly increase. However, the DPIIT will need to do its bit to energize the ecosystem by responding promptly to applications for recognition.
- Significantly, the February 2019 Notification has also exempted investments from non-residents and venture capital companies and funds from the 25 crore threshold for calculation of paid-up share capital. This will give confidence to not only start-ups, but also to a number of individual non-resident angel investors and venture capital funds/companies investing in Indian start-ups.
- The February 2019 Notification introduces the concept of self-certification by start-ups, in order to certify compliance with the conditions for claiming exemption from angel tax. This follows other areas of start-up compliance which also rely on self-certification, such as labour law compliance, and is intended to improve the ease of doing business in India.
Grey Areas: There are still some concerns that remain unaddressed by the February 2019 Notification, and that may continue to cause heartburn among the investor and start-up community in India.
- While widening the scope of start-ups that can seek recognition from the DPIIT, the February 2019 Notification has not specified a time limit within which the DPIIT ought to respond to applications for recognition. Therefore, the alacrity with which the DPIIT responds to applications in the days ahead will determine whether the February 2019 Notification has indeed been a confidence building measure or not.
- Significantly, the February 2019 Notification has stipulated that the tax notices already issued to start ups will continue to be pursued by the tax authorities. Considering that over 73% of start-ups have reportedly received such notices, it is disappointing that the February 2019 Notification did not provide a timeframe for resolution of such notices, or provide for a fast-track disposal of these notices. Hence, these proceedings may take years to resolve and require significant time, attention and costs for start-ups.
- Another point to note is that the self-declaration that is specified in Form 2 of the February 2019 Notification only stipulates that the start-up has not utilized and will not utilize the proceeds of the investment in purchasing prohibited assets. The self-declaration does not extend to the other eligibility criteria required to be fulfilled by a start-up i.e. that it is registered with the DPIIT and that its paid-up share capital post issuance of shares does not exceed Rs. 25 crores. Potentially, these conditions will be subject to verification through audits and investigations by the tax officers, which may also open up the gates to further tax notices.