Context: The Central Board of Direct Taxes (CBDT) has issued a directive aimed at ensuring that Department for Promotion of Industry and Internal Trade (DPIIT) recognized start-ups are not burdened with unnecessary scrutiny under the revised angel tax provisions in the Finance Act, 2023.

New Tax Directives Related to Start-ups

• The CBDT has directed its officers to refrain from scrutinizing the angel tax provisions for start-ups that have received recognition from the DPIIT.

• This directive comes in response to concerns raised by many start-ups regarding scrutiny notices for angel tax.

Recent notifications regarding the angel tax

Exemptions given to investors from 21 countries

• In May 2023, the Finance Ministry had exempted investors from 21 countries including the US, UK and France from the levy of angel tax for non-resident investment in unlisted Indian start-ups.

• However, the list excluded investment from countries like Singapore, Netherlands and Mauritius.

Final valuation rules for foreign and domestic investors

• In September 2023, the Finance Ministry notified final valuation rules for foreign and domestic investors into unlisted companies such as start-ups under the new angel tax mechanism.

• The rules had accounted for the industry’s calls by addressing an additional sub-clause of compulsorily convertible preference shares (CCPS).

• CCPS are a type of preferred stock that can be converted into a fixed number of equity shares of the issuing company after a specified date.

• It stated that the valuation of CCPS can also be based on the fair market value of unquoted equity shares.

• The tax department has asked its field officials to not do verification for the “recognised” start-ups for cases pertaining to Section 56 (2) (viib) of the Income-tax Act.

• There are 99,380 startups recognised by the DPIIT.

• Besides, in cases where proceedings are auto generated, contentions of such recognised startup companies on the issues will be summarily accepted.

• However, they may be subject to verification for other taxation issues.

• This clarification by the tax department comes after many startups had raised concerns about receiving scrutiny notices for angel tax.

• Many startups received notices under Section 56(2)(viib). They were asked to furnish income tax returns (ITRs) of their stakeholders for the past three consecutive years.

Angel Tax

• Angel tax is an income tax levied at the rate of 30.6% when an unlisted company issues shares to an investor at a price higher than its fair market value.

• Angel Tax is a term basically used to refer to the income tax payable on the capital raised by unlisted companies via the issue of shares through off-market transactions.

• This tax is levied on the capital raised via the issue of shares by unlisted companies from an Indian investor/ foreign investors from certain countries if the share price of issued shares is seen in excess of the fair market value of the company.

• The excess realization is considered as income and therefore, taxed accordingly.

• E.g., If the fair market value of a start-up share is Rs 10 apiece, and in a subsequent funding round they offer it to an investor for Rs 20, then the difference of Rs 10 would be taxed as income.

• Angel tax gets its name from the wealthy individuals (“angels”) who invest heavily in risky, unproven business ventures and start-ups, in the initial stages when they are yet to be recognised widely.

• Fair market value is the price of an asset when buyer and seller have reasonable knowledge of it and are willing to trade without pressure.

• Initially, angel tax was applicable only to investments made by resident investors. The Finance Act, 2023 extended this provision to include foreign investors as well.

• This means that when a start-up raises funding from a foreign investor, it will also be counted as income and subjected to taxation.

• However, DPIIT-recognized start-ups are now excluded from the angel tax levy.

What is the rationale behind introducing Angel Tax?

• Rule related to Angel Tax is described in Section 56(2)(viib) of the Income Tax Act, 1961.

• This clause was inserted into the act in 2012 to prevent laundering of black money, round-tripping via investments with a large premium into unlisted companies.