Understanding the Concept of Angel Tax in Angel Funding

Angel Tax, a term commonly associated with the financial regulations surrounding startup funding, is a tax that unlisted companies or startups are liable to pay on the capital they raise through the issue of shares. This article aims to demystify the concept of Angel Tax, its legal basis, and how it impacts startups and angel investors.

What is Angel Tax?

Angel Tax is essentially a levy imposed on the funding received by startups from external investors. This tax is specifically applicable when the startup receives angel funding at a valuation higher than its Fair Market Value (FMV). Essentially, any capital raised over the FMV is treated as income and is subject to taxation.

Legal Basis and Provisions

Angel Tax is not specifically defined in the Income Tax Act 1961. However, under section 56(2)(viib) of the Income Tax Act 1961, if a private limited company receives any consideration for the issue of equity shares that exceeds the fair market value (FMV) of those shares, such excess consideration is taxable. This is known as Angel Tax.

How Angel Tax is Calculated

The concept of Angel Tax revolves around the relationship between the funded value and the FMV of the shares issued. Consider the following example:

Company X aims to raise funds from Angel Investors. An investor decides to fund 100 Crores by taking 1 Lakh shares. Based on the investor’s valuation, the per share value is calculated as 100 Crores / 1 Lakh shares 10000 per share. However, if the market valuation of the shares is only 5000 per share, the additional funding of 50 Crores (5000 per share * 50Lakh shares) is considered to be funded over the FMV. In such a scenario, Company X would have to pay a tax of 30.9% on the 50 Crore overvaluation.

For instance, if Company X raises 50 Crores at a valuation higher than the FMV, it would need to pay a tax of approximately Rs 15 Crores (30.9% of 50 Crores).

The Impact on Startups and Angel Investors

Angel Tax is a 30% tax that is levied on the funding received by startups from external investors. However, this tax is only applicable when startups receive angel funding at a valuation higher than its FMV. The tax is considered as income to the company and is therefore subject to taxation.

The rationale behind introducing the tax under section 56(2)(viib) in 2012 was to combat money laundering. It stated that bribes and commissions could be disguised as angel investments to evade taxes. However, given the potential to harass genuine startups, the provision was rarely invoked.

Despite the legal framework, the practical implications of Angel Tax can significantly impact the funding dynamics of startups and the return on investment for angel investors. Startups must carefully manage their valuation when raising funds to avoid unnecessary tax liabilities.

Conclusion

The concept of Angel Tax is a critical aspect of the financial landscape for startups and angel investors. Understanding the nuances of this tax is essential for making informed decisions and navigating the complexities of startup funding. By aligning their valuation strategies with the FMV, startups can mitigate the risk of Angel Tax and ensure a smoother journey to growth and success.

If you require further assistance or need more information on Angel Tax, feel free to contact Namaste Rohit Kashyap.