Angel Tax Exemption for start-ups: Every Start-up should know about it

Introduction:

Section 56(2) (viib) of the Income Tax Act, 1961 has been a cause of concern for the start-ups due to the tax levied under this section on the capital raised by the start-ups in India. This section was actually introduced for preventing money laundering activities by issuing shares at an excessive premium above the fair market value (FMV) of the shares. This is commonly known as “Angel Tax” but the section became a nightmare for the newly thriving start-ups who needed funds for fulfilling their aspirations. However, the Government later issued a notification dated 19.02.2019 giving adequate relaxations for the eligible start-ups from the ill-effects of “Angel Tax’. This article is dedicated to the detailed evaluation of section 56(2)(viib) of the Income Tax Act from the perspective of the angel tax exemption for start-ups.

Reasons for introduction of Angel Tax

The main reason for the introduction of the ‘Angel Tax’ was to tax the excessive share premium received over and above the FMV by the private companies, which was extensively being used as a mechanism for accounting for unaccounted money or black money. Thus, this is one of the anti-abuse provisions introduced to prevent money laundering.

What Section 56(2) (viib) says…

Further, another proviso was added to the section by Finance Act, 2019 which we will discuss in the latter part of this article.

Analysis of Section 56(2) (viib)

• As it is clear from the reading of the section that the above section is applicable in case of a closely held company or private limited company where it is in receipt of consideration of issuance of shares at a premium that is in excess of its fair market value (FMV).
• In other words, the private limited companies in India should ensure that they issue shares to any other person resident in India at its FMV which may be determined using the Net Asset Value Method or any other prescribed method. In case the shares are issued by them at a price in excess of the FMV, the implications of section 56(2) (viib) will get triggered and the company shall be liable to pay tax on such excess premium received by it.
• Please keep in mind that the above provision is applicable only where the private limited company receives consideration for the issue of shares from a person resident in India. If such a company receives an excess premium in case of issue of shares to a non-resident, the tax implications of section 56(2) (viib) will not come into play.

However, the above section shall not be applicable where the consideration of the issue of shares is received by a venture capital undertaking from a venture capital company or a venture capital fund or a specified fund. Further, the Central Government may also notify the class of persons on which the aforesaid section shall not apply.

Section 56(2) (viib) a cause of concern for start-ups

As evident from the above analysis, the section became a cause of concern for the start-ups as it hampered them from getting funds for breeding their start-ups. According to a survey, nearly 73% of the start-ups received one or more Angel Tax notices. Later based on representations and because in the start-up ecosystem shares are issued at a premium and value the long-term potential of the company which may not be captured under the valuation methodology specified (Net Asset Value) under this section, an exemption was provided to start-ups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT).

Now, in the next section of the article, we will discuss how start-ups can avail exemption from Angel Tax.

How to get exemption from Angel Tax

To exempt start-ups from the implications of section 56(2)(viib), the Government issued a notification dated 19.02.2019 [Read Notification] that section 56(2)(viib) shall not apply if an approved eligible start-up company receives consideration for the issue of shares from resident investors. However, this is subject to fulfillment of certain conditions which we will discuss in this article. It is to be noted that receiving consideration for the issue of shares from non-residents is already out of the ambit of section 56(2) (viib).

To get Angel Tax exemption, you may call our executives at 09660930417 or click on the following link: https://www.taxwink.com/service/start-up-india-registration

Meaning of start-up for purpose of Angel Tax Exemption

According to the notification, an entity shall be considered as a start-up:

• Up to a period of 10 years from the date of incorporation/ registration, if it is incorporated as a private limited company or as a partnership firm or LLP;
• Turnover of the entity for any of the financial years since incorporation/ registration has not exceeded INR 100 crores;
• The entity 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

Provided that an entity formed by splitting up or reconstruction of an existing business shall not be considered as a ‘Start-up’.

Who is an eligible start-up for section 56(2) (viib)

A start-up shall be eligible for the exemption from Angel Tax if it has been recognized by DPIIT and the aggregate amount of its paid-up share capital and share premium of the start-up after issue or proposed issue of shares does not exceed INR 25 crores.

Further in the calculation of threshold of INR 25 crores, the amount of paid-up share capital and share premium in respect of shares issued to any of the following persons will not be included:

• A Non-resident or
• A Venture Capital Company pr
• A Venture Capital Fund

For DPIIT Registration, you may call our executives at 09660930417 or click on the link: https://www.taxwink.com/service/start-up-india-registration

But, the exemption from Angel Tax is subject to certain conditions which an eligible start-up should take care of. These are given in next section of the article. Keep Reading…

Conditions for exemption from Angel Tax to be fulfilled

An eligible start-up shall get exemption from Angel Tax as given u/s 56(2) (viib). However, the exemption is provided subject to the condition that the start-up should not invest, within 7 years from the end of the latest financial year in which the shares are issued at a premium, in any of the following:

• Building or land for the purpose (other than own use or as stock in trade or for the purpose of renting)
• For advancing loans (other than where the lending of money is the substantial part of the business of the start-up)
• Capital contribution to any other entity
• Shares and securities
• Motor Vehicle, aircraft, yacht, or any other mode of transport, the actual cost of which exceeds INR 10 Lakhs (other than that held by the start-up for the purpose of plying, hiring, leasing, or as stock-in-trade, in the ordinary course of business
• Jewellery (other than that held by the start-up as stock in the ordinary course of business)
• Archaeological collections & Artifacts etc.

Author's Note

Consequences of failure to fulfill conditions for exemption from Angel Tax

Second Proviso to Section 56(2) (viib) reads as below:

Analysis:

• If any eligible start-up fails to comply with the conditions as referred in the Notification, the exemption from Angel Tax allowed to such start-up earlier shall be revoked.
• The effect of the revocation is that any consideration received before failure by such start-up which is in excess of the fair market value of shares will be deemed to be the income of the start-up for the financial year in which exemption is revoked.
• Further, it shall be deemed that the start-up has under-reported its income and shall be liable for consequences u/s 270A i.e. penalty equal to 200% of the amount of tax payable on under-reported income.

Authors’ Note

Read Related Article:

Income Tax Benefits for Startups

Startup India Seed Fund Scheme

Startup India Registration- Procedure and Benefits

Disclaimer: The above article is meant for educational purposes only. Readers are requested to act diligently and under consultation with any professional before applying the information contained in this article.