Unlocking investment opportunities: Discover the investor class exempted from Angel Tax Provision

Authored by Mohit Ralhan, Chief Executive Officer of TIW Capital

With India emerging as the third largest startup ecosystem in the world, with more than 85,000 start-ups and more than 100 unicorns, there is increasing interest from investors to ride this trend. While venture capital firms have taken significant bets on Indian startups, investing more than USD 90 billion in the last 5 years, this asset class has been largely absent from the portfolio of high-net-worth individuals. India is currently going through an entrepreneurship boom, which is a critical component in India’s growing stature in the world economy. As India is set to emerge as the third-largest economy in the world by the end of this decade, there is huge potential of making better returns by investing in Indian startups. 

While investing in startups does offer significantly high return potential, one important factor is to understand the tax treatment of these investments, especially the angel tax provision. The angel tax provision was initially introduced in 2012 to prevent money laundering through investments in startups since the valuation at which the capital gets invested is subjective and can theoretically be astronomically high. The tax applies to funds raised by unlisted companies through off-market transactions where the price at which the new shares are issued exceeds their fair market value (FMV).  

When a startup receives equity investment from an Indian investor that surpasses the fair value of shares, it is considered "Income from Other Sources" and is taxed at a rate of 30.9 per cent in the hands of the startup. The assessing office has the authority to question and dispute the valuation of startups and this has been a cause of multiple tax-related litigations.

Initially, the angel tax provision applied only to investments from resident investors. However, with the Finance Act of 2023, foreign investors were also brought under the purview of angel tax starting from FY 2024. This was a setback as a substantial portion of funding for early-stage startups comes from foreign investors. But as a relief, the government has exempted foreign portfolio investors, including sovereign funds and pension funds from 21 nations. 

The list of 21 countries includes Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Iceland, Israel, Italy, Japan, Korea, New Zealand, Norway, Russia, Spain, Sweden, the United Kingdom, and the United States. However, investors should be mindful that entities registered in jurisdictions like UAE, Singapore and Mauritius which have historically contributed significantly to FDI in India have been kept out of this exemptions list.

There are other several categories of investors who are exempted from the angel tax provision. Government and government-related investors, such as central banks, sovereign wealth funds, and international or multilateral organizations, or where ownership of the government directly or indirectly is 75 per cent or more. The insurance companies are also exempted. Banks or entities involved in the insurance business. SEBI-registered Category I Foreign Portfolio Investors and broad-based pooled investment vehicles or funds where the number of investors is more than 50 excluding hedge funds are also exempted.

Clearly, the government has made enough provisions to exempt institutional investors from the ambit of the Angel tax. Therefore, for HNIs, one straightforward way to participate in the Indian start-up boom is to channel their investments through alternative investment funds (AIFs) registered with SEBI, which are also exempted from Angel tax. They can invest with an established fund manager with a track record of generating returns. The investors can start with as little as INR 1 crore investment and get the benefit of a fund manager’s skill along with diversification, since the AIF pools money from various investors and then build a diversified portfolio of 5 to 10 companies. 

In addition, the Department for Promotion of Industry and Internal Trade (DPIIT) kept over 80,000 startups registered with them from its purview. Investors can look for startups that have been recognized by the DPIIT. The DPIIT maintains a list of startups on its website that have been recognized for the angel tax exemption and HNIs can directly invest in such companies without triggering angel tax provisions. 

Finally, connecting with other investors and entrepreneurs in the startup ecosystem can be an effective way to discover eligible startups. Fellow investors may possess valuable information regarding startups that qualify for the exemption and may be willing to share the knowledge.

Given the returns potential and the ever-expanding start-up ecosystem in India, this asset class should be part of the overall investment portfolio of HNIs, it is worth understanding the angel tax provision and finding exempt ways to invest.