Mint Explainer: Why the angel tax needed to be abolished

The Union government has finally heeded the pleas of startups and investors who have been crying hoarse for 12 years for the removal of the so-called angel tax. It had been introduced as an anti-money laundering measure. On Tuesday, Union finance minister Nirmala Sitaraman, while presenting her Budget for 2024-25, announced the abolition of the angel tax for all investors and asset classes. Startups and investors have cheered the decision, although there’s the fine print that needs to be reckoned with. Mint explains why startups and investors saw the angel tax as a major hindrance to accessing capital, and what changes now.

What was the concept of angel tax? 

For most entrepreneurs who start a business, the first round of financial backing comes from family and friends. Some are even able to tap so-called angel investors—typically wealthy individuals and family offices. The government decided to tax unlisted companies if they issued shares to their investors at a premium to their fair market value. The excess realization is considered income and taxed accordingly. 

Why was the angel tax introduced? 

Former Union finance minister P. Chidambaram first announced the tax in 2012 to clamp down on potential money laundering, inserting Section 56 (2) (viib) in the Income Tax Act as “Measures to prevent generation and circulation of unaccounted money”. It targetted unlisted companies issuing securities to investors. 

Since 2016, this section has been applied to startups that raise capital from angel investors for their nascent ideas. The angel tax originally applied only to investments from Indian residents but was extended to non-residents (with carve-outs) from the financial year 2023-24. 

Startups and investors have not challenged the validity of the angel tax, but have also complained about its abuse and misuse by authorities.

What were their main points of contention? 

Startups and investors have said such a tax on investments was antithetical to capital formation. According to them, a high share premium does not indicate “unaccounted funds”. Rahul Charkha, partner at Economic Laws Practice, said key areas of litigation challenging the angel tax included the valuation methodology, treatment of estimated figures in the discounted cash flow method, scrutiny of funding sources and investor credibility, retrospective application, and taxation upon conversion of convertible instruments into equity.

Were any exemptions introduced?

In 2019, the government exempted startups registered with the Department for Promotion of Industry and Internal Trade from the angel tax. However, only 125,000 startups were registered as at the end of March 2024, the Economic Survey shows. That’s not even half of the startups in the country, say industry experts.

Does the abolition of the angel tax apply to all investors?

The government’s decision to abolish angel tax applies to all classes of investors, a huge reform that startups and investors have been petitioning for more than a decade. The decision, however, is prospective, and does not apply to retrospective cases and tax demands already raised.

How have investors reacted to the move?

Despite the fine print on retrospective cases, which is probably yet to sink in, startups and investors appear relieved by the government’s decision.

“Given the mandatory dematting of securities, Section 68, disclosure of unlisted investments in tax returns has plugged the transparency gap for which Angel Tax was created,” said Siddarth Pai, founding partner, 3one4 Capital, an early-stage venture capital firm. “It took 12 years, but the startup industry can heave a sigh of relief that the dreaded angel tax has been removed.”