Angel funding serves as a vital financial lifeline for startups, providing the necessary capital to transform innovative ideas into viable businesses. However, it's critical for startup founders to understand the tax implications associated with such investments to ensure compliance and optimize financial planning.

This article by CA Manish Mishra investigates into the key tax considerations for startups receiving angel funding, with a focus on the Indian context.

Angel Tax

In India, the term "Angel Tax" refers to the tax levied under Section 56(2)(viib) of the Income Tax Act, 1961. This provision was introduced to curb money laundering through the infusion of unaccounted money into companies under the guise of share capital. It mandates that when a closely held company issues shares at a price exceeding their fair market value (FMV), the excess amount is treated as income and taxed accordingly. The tax rate applicable is 30.9%, including cess.

- Applicability of Angel Tax

Initially, Angel Tax was applicable only to investments made by resident investors. However, the Finance Act 2023 expanded its scope to include non-resident investors as well. This means that funds raised from both domestic and foreign investors, exceeding the FMV of shares, could attract Angel Tax.

- Exemptions and Eligibility Criteria

To promote the startup ecosystem, the Indian government has provided certain exemptions from Angel Tax. Startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) can apply for exemption under Section 56 of the Income Tax Act, provided they meet specific criteria:

• DPIIT Recognition: The entity must be a DPIIT-recognized startup.

• Investment Threshold: The aggregate amount of paid-up share capital and share premium of the startup after the proposed issue of shares should not exceed INR 25 crore.

• Investor Criteria: Resident investors should have a minimum average returned income of ₹25 lakh for the preceding three financial years or a net worth of ₹2 crore as of the last date of the preceding financial year.

Recent Developments

In a significant move to bolster the startup ecosystem, the Indian government announced the abolition of Angel Tax in the Union Budget 2024, effective from the financial year 2025-26. This decision is expected to simplify the funding process and foster growth within the startup community.

Tax Implications for Startups

While the abolition of Angel Tax is a positive development, startups must remain vigilant about other tax implications associated with receiving angel funding:

- Valuation Compliance: Ensuring that the valuation of shares aligns with regulatory standards is critical to avoid scrutiny. Startups should maintain thorough documentation to substantiate their valuations.

- Equity Structuring: Issuing shares at a premium requires careful consideration of the company's valuation and growth prospects. Proper structuring can prevent potential tax liabilities.

- Reporting Obligations: Startups must comply with reporting requirements, including the filing of necessary forms and disclosures with tax authorities, to maintain transparency and avoid penalties.

- Utilization of Funds: The application of received funds should be in line with the business objectives stated during fundraising to ensure compliance with tax regulations.

Tax Implications for Investors

Angel investors should also be aware of the tax implications on their investments:

• Capital Gains Tax: Profits earned from the sale of shares are subject to capital gains tax. The rate varies based on the holding period of the investment.

• Tax Benefits: Investors may be eligible for tax deductions under specific sections of the Income Tax Act, provided certain conditions are met.

Best Practices for Startups

To the tax site effectively, startups should consider the following best practices:

• Seek Professional Advice: Engaging with tax professionals can provide tailored guidance and ensure compliance with the latest regulations.

• Maintain Accurate Records: Keeping detailed financial records and documentation of all transactions is essential for transparency and audit readiness.

• Stay Updated: Regularly monitoring changes in tax laws and regulations will help in proactive compliance and strategic planning.

GenZCFO Advice

Receiving angel funding is a significant milestone for startups, offering the capital needed to scale operations and innovate. However, understanding the associated tax implications is critical to ensure compliance and optimize financial health. With the recent abolition of Angel Tax, the Indian startup ecosystem is poised for a more conducive funding environment. Nonetheless, startups must continue to adhere to other tax regulations and maintain best practices to sustain growth and success. Feel free to contact us if you have any queries.