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The Saga of Start-ups and Angel Tax


What is a Start-up?

A startup is a company that is in the initial stages of its operations. The promoters basically come up with an idea/ business model that targets the market needs by developing or offering an innovative product, process or service. These companies generally look for investments to scale up their idea/business model from angel investors who perceive the value in the said business model and are eager to take the risk and invest in the given startup.

Start-up India Initiative

The Government of India introduced ‘Start-up India‘ initiative for creating a conducive environment for the start-up companies in India. The CBDT inserted Section 80-IAC in IT Act vide Finance Act 2016. This provision provides for 100% tax deduction in respect of profits of start-ups which are approved by the Department of Industrial Policy and Promotion (DIPP).

What is Angel Tax?

As a general rule, any premium receipts by the assesses towards issue of share capital being capital receipts, should be out of purview of tax but the Income-tax dept,  vied The Finance Act 2012, as part of the Measures to Prevent Generation and Circulation of Unaccounted Money  has introduced Section 56(2)(viib) of the Income Tax Act wherein as per the said section, If a closely held company issues shares at  more than its fair market value (FMV) to an Indian resident, then the amount(premium) received in excess of fair market value of shares will be deemed to be income of the startup and shall be charged to tax as an income from other sources in the hands of the issuer.

Conditions for applicability of Sec 56(2)(viib) :

(1) It applies to a closely held company, i.e., a company other than the company in which the public are substantially interested.
(2) The consideration should be received from a resident. Therefore, consideration received from a non-resident is not covered under this clause.
(3) The consideration should be received for the issuance of shares.
(4) The issue price of shares should exceed the face value of such shares.

If all these conditions are satisfied, then the consideration received in excess of the FMV of the shares is considered as an income of the company issuing the shares and is subject to tax.

This section exempts a venture capital undertaking receiving the consideration for issue of shares from a venture capital company or a venture capital fund registered with the Securities and Exchange Board of India (SEBI).

What is FMV?

As per the said Section 56(2)(viib) The FMV shall be higher of the following :

(1) As per the methods prescribed in Rule 11UA of the Income Tax Rules, 1962.
(2) As may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value on the date of issue of shares of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature.

Whichever is higher

Now the Rule 11UA again provides two methods of valuation, i.e., Net Asset Value Method and the fair market value determined by the merchant banker as per the Discounted Free Cash Flow method. Earlier, the Chartered Accountant was also allowed to determine the FMV using the Discounted Free Cash Flow method. However, after the amendment by the Income-tax (Sixth Amendment) Rules, 2018, w.e.f. 24-5-2018, only merchant banker can determine the FMV.

Issues Faced by Startups:

As per Section 56(2)(viib) and Rule 11UA(2), Discounted Cash Flow Method (DCF Method) or Net Asset Value Method (NAV Method) can be used to calculate the Fair Market Value of the shares. While most startups, as discussed earlier, being in initial stages of their operations, do not have many assets and generally have very less net assets they tend to follow DCF method as they believe that their idea/business model will fetch remarkably good future cash flows.

Whereas this mechanism of share valuation adopted by the startups and its test by the tax authorities has been at the core of tax litigation. The methods adopted by the taxpayers are being examined and rejected by the Assessing Officers despite the startups having followed the methods prescribed by the law.

The taxmen have been issuing notices not just to the startups raising funds but also to the angel investors asking for the details of the angel investors, their source of income, bank statements and copy of Income Tax Returns and  the valuers asking for the basis on which the valuation certificates have been issued by them Thus, it is discouraging the angel investment in startups.

The startups have been receiving notices from the Income Tax department despite the fact that the DIPP provided relief to them by issuing notification G.S.R. 364(E) dated 11-04-2018. It requires start-ups to file new Form-1 and Form-2 in order to claim tax incentives. The application in Form-1 shall be filed along with prescribed documents before CBDT to obtain a tax exemption certificate under Section 80-IAC while Form-2 has to be filed to claim exemption from the applicability of the provision of Angel tax. The notification also prescribed certain conditions which have to be fulfilled by the start-ups and their investors in order to become eligible to file these Forms.

Interim Relief


On the hue and cry made by the startups, the DIPP took up this matter with the Department of Revenue (DoR) to stop any kind of harassment to start-ups. Consequently, the DIPP issued a new notification simplifying the process for seeking exemption from applicability of Angel tax. The DIPP has substituted Para (4) of its earlier issued Notification no. GSR 364(e) which provides for conditions to be fulfilled by the start-up cost. and investors for claiming exemptions. The relaxations provided by the DIPP’s new notification, which shall be in force from January 16, 2019, are enumerated in subsequent paragraphs.

The exemption from Angel tax has been extended to all previous investments as well. Earlier, a start-up could claim exemption from Angel tax only in respect of its proposed issue of shares. The new notification extends the benefit for both, existing issues and shares proposed to be issued by the start-ups.

The Central Board of Direct Taxes (CBDT) has also been mandated to grant approval of exemption within a period of 45 days from the date of receipt of application in Form 2.

The threshold limit of paid-up share capital of start-up remains unchanged in the new notification. The aggregate amount of paid-up share capital and share premium of the start-ups after the proposed issue of shares should not exceed Rs. 10 crore in order to become eligible for tax exemption.

The investors should have returned the income of Rs. 50 lakhs or more in the financial year immediately preceding the year of investment. Earlier this limit was Rs. 25 lakhs which shall be calculated by taking an average of returned income of preceding 3 financial years. Further, the net worth of an investor, as on the last date of the financial year, immediately preceding the year of investment/proposed investment, should be Rs. 2 crores or amount of investment made (or proposed to be made) in the startups, whichever is higher. Earlier, they were required to have a net worth of Rs. 2 crores or more as on the last date of the preceding financial year.


After the issue flared up and after representation from DIPP side, the CBDT in a move that is set to provide immediate relief to startup community with regards to angel tax, the Central Board of Direct Taxes on 20-12-2018 said that no coercive action will be taken against them to recover the demands of completed assessments under income-tax made by the AOs.

Subsequent developments

After interim relief, as above, the CBDT acted swiftly. The next day a meeting was attended by Revenue Secretary Ajay Bhushan Pandey, Department of Industrial Policy and Promotion (DIPP) Secretary Ramesh Abhishek and the Chairman of the CBDT, Sushil Chandra. In this meeting, the following decisions were taken:

(i) A panel of eminent technical experts from IITs and IIMs will be set-up soon to draw up a new framework for recognition of startups, including the issue of the premium charged by them on their shares.
(ii) “CBDT further said that it has also been decided that meanwhile no coercive action/measures to recover the demands of completed assessments under Income-tax would be taken”, said a statement issued by the government after a high-profile meeting.
(iii) The committee will also consider grant of tax exemptions and other connected matters.
(iv) The Committee will also look at issues pertaining to tax exemption available to startups under the StartUp India programme.

Committee report

The committee of experts will make a recommendation to DIPP on the above issues pertaining to the startups.


While it is necessary to curb the menace of tax avoidance/ evasion under the guise of issuing shares at a premium and to keep in check bogus entities from indulging in money laundering activities, one cannot look at every entity established in the same lines as the said bogus entities. Genuine startups, on a case to case basis, should be treated separately without applying the rigours of deeming provisions of Sec 56(2)(viib) mechanically which would otherwise choke the genuine startups and hamper the startup ecosystem which is against the spirit of startup India Initiative. The CBDT and Govt. should expedite the process and mechanism for recognizing genuine startups.

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