Angel investment at high premium under Income-Tax department scanner

Notices seeking explanation served to start-ups

Indian start-ups that raised capital from domestic investors at an “excessive premium” between Assessment Years 2018-19 and 2020-21 have come under the income-tax (I-T) department scanner.

The tax department has asked a considerable number of start-ups, including those in the financial technology and education space, to justify their shares issued at a premium to domestic investors under angel tax provisions in a recent communiqué, informed two people in the know.

The excess premium received on the sale of shares by an Indian unlisted company to either foreign or domestic investors will be construed as ‘income from other sources’ and liable for angel tax.

One of the tax notices sent to a start-up firm reads: “Why should we not consider the valuation as above market rates and not tax the same under Section 56(2)(vii)(b) (also known as angel tax) of the I-T Act?”

“Notices are based on information flagged on the tax department’s insight portal, following a risk assessment analysis for a selection of scrutiny cases. Neither are the notices random nor are they excessive in number,” said a tax official privy to the matter.

These notices were issued between mid-March and the first week of April this year.

Officials, however, clarified that government-registered start-ups are exempt from angel tax. About 95,000 start-ups are registered with the Department for Promotion of Industry and Internal Trade.

Experts say that the start-up exemption provided by the government to angel tax applies to only a few thousand start-ups and does not extend to all registered start-ups since there are stringent conditions attached to claiming such exemption.

“A start-up valuation is largely a function of an investor’s gut feel on the likelihood and speed of scaling up of a business idea. It is very difficult for a valuer to arrive at the same value that any investor is willing to commit to. A lesser valuation by the valuer will breach the Foreign Exchange Management Act (FEMA) guidelines and a higher valuation by the valuer will lead to angel tax. Both give unacceptable commercial outcomes,” said Bhavin Shah, partner, PwC India.

While the government has been supporting start-ups at several levels, this is a critical area where the government’s sharp intervention is necessary, added Shah.

In the Finance Bill, 2023, the Centre proposed to omit the condition of residency under the angel tax provision, making it applicable even when shares are issued to non-resident investors. Earlier, only resident investors were covered under the angel tax provision.

Mitil Chokshi, Chokshi and Chokshi LLP, said every resident making investments in Indian companies will need to justify the share issue valuation, more particularly for start-ups where these are significantly higher or angel investments, in line with acceptable methods of valuation.

There are several litigations currently underway concerning shares issued to companies at a higher-than-fair value. It will now become imperative for resident assessees to ensure tax-justifiable valuations, he said.

On the new rule, the government has received several suggestions, including easing certain conditions of registration, such as limiting the aggregate paid-up share capital and share premium (after issue) to Rs 25 crore, apart from implementing valuation methods in line with FEMA guidelines.

The Ministry of Finance is working on the valuation method as well as the exemption list of foreign investors, said sources quoted earlier.

They added it may consider keeping certain categories of investors beyond the tax pale, especially those registered with regulatory authorities.

Under scrutiny

I-T seeks justification for issuance of shares to domestic investors at 'excessive premium'

Notices issued for assessment years 2018-19, 2019-20 and 2020-21

Indian angel investors are usually HNIs and family offices that invest in start-ups

Angel tax was introduced as an anti-abuse measure in 2012

It is levied on start-ups at 30.9% on net investments in excess of fair market value

Finance Bill 2023 extends the tax provision to foreign investors