India’s Angel Tax

India currently ranks third in the world for startup activity. The sector has given rise to some of the most prosperous enterprises, from education and technology to construction. India consequently became a desirable location for numerous foreign venture capitalists, but as the number of investors recently increased, the nation is at risk of developing bubbles and money laundering. As a result, the government imposed the "Angel Tax" to deter the creation and use of unreported funds through investments. 

What is the Angel Tax?

Angel taxes are levied on startup funds exceeding the company's fair market value. The government contrasts the fair market value with the angel investor's evaluation to determine the company's market value.  In other words, if a startup gave shares to an angel investor at a price greater than their fair market value, the difference was treated as "income from other sources" and taxed accordingly. 

It is essential to highlight that only startups that conform to the Indian government's definition of a "startup" are subject to the Angel Tax.

Angel Tax Effects and Related Issues

Since its introduction, the tax has been criticized by investors, industry analysts, and entrepreneurs for being burdensome and unfavorable to startups. They claimed that determining a startup's fair market value was subjective and could not be standardized. A startup's valuation might be based on anything as simple as predicted returns at a specific moment and is subject to negotiations between the business and the investor. As a result of the COVID-19 outbreak in 2020, many startups experienced a funding shortage. Another issue was that the assessing officer, a key tax official who examines the books, would use cash-discounted flow to calculate the fair market value, which was not a good practice for startups. 

Finally, this tax may delay or even prevent early-stage enterprises that require significant initial capital investment from producing revenue and profit since they must pay an angel tax before they begin operations.

Proposed solutions to Valuation Rules 

Currently, income tax laws allow taxpayers to use either the net asset value technique or the discounted cash flow approach to assess the fair market value of unlisted equity shares. The Indian government recently released complete valuation rules proposing some additional methodologies to determine the fair market value of shares issued by Indian companies to nonresident investors to address investors' and investees’ concerns about the expanded scope of the angel tax and to introduce some flexibility on share valuation for determining its applicability. These include the replacement cost approach, the probability-weighted expected return method, the comparable company multiple method, the option pricing method, the milestone analysis method, and the method for analyzing returns over time. In addition, the draught rules provide a 10% safe harbor for both domestic and nonresident investors.

The Indian government took various measures to address the concerns related to the angel tax. These included simplifying the valuation methodology, increasing the threshold for exemption from angel tax, and providing relief to recognized startups. However, the issue continued to be a matter of debate and concern for the startup community.

Written by Ulpan Nurdilda | Proofread by Yasmin Uzykanova