Why in the News?

Finance Minister announced the abolition of the angel tax, aiming to strengthen the startup ecosystem and support innovation in India.

What is Angel Investment?

An angel investor is an individual who provides financial backing to early-stage startups or entrepreneurs, typically in exchange for equity in the company.
Angel investors are typically high-net-worth individuals who invest their own personal funds, rather than investing on behalf of a firm or institution.
Features of Angel Investing: Early-stage funding, equity investment, high-risk, high-reward, active involvement,personal investment,f lexible terms and shorter investment horizon.

Referred to as Angel Tax, this rule is described in Section 56(2)(vii)(b) of the Income Tax Act, 1961.
Essentially it’s a tax on capital receipts, unique to India in the global context.
This clause was inserted by the Finance Act in 2012 to prevent laundering of black money, round-tripping via investments with a large premium into unlisted companies.
The tax covers investment in any private business entity, but only in 2016 was it applied to startups.

The complicated nature of VC fundraising with offshore entities, multiple limited partners and blind pools is contentious.
There has been some element of money laundering or round-tripping under guise.

The Angel Tax is being levied on startups at 9% on net investments in excess of the fair market value.
For angel investors, the amount of investment that exceeds the fair market value can be claimed for a 100% tax exemption.
However, the investor must have a net worth of ₹2 crores or an income of more than ₹25 Lakh in the past 3 fiscal years.

Share Valuation: The tax impacted the valuation of shares, causing complications for startups in raising funds.
Discounted Cash Flow (DCF) Method: Issues arose with the treatment of estimated figures in the DCF method, leading to disputes.
Scrutiny of Funding Sources: The scrutiny of funding sources and investor credibility added another layer of complexity for startups.
Retrospective Application: The retrospective application of the tax and its effect on the conversion of convertible instruments into equity were also significant points of dispute.

Startups has long advocated for a more supportive and less restrictive environment for fundraising.
With this change, the government aims to create a more favourable atmosphere for innovation and investment in India.

PYQ:

[2014] What does venture capital mean?

(a) A short-term capital provided to industries.

(b) A long-term start-up capital provided to new entrepreneurs.

(d) Funds provided for replacement and renovation of industries.