While this issue has already been raised by startups, the government’s response has not been reassuring, despite previously signaling more flexibility for angel and investment.

In 2019 the Indian government said in parliament that angel investments are exempt from tax under the Income Tax Act 1961. “Startups that receive investments from the Ventures Capital Fund are exempt from tax under Section 56 (2) (vii b) of the Income Tax Act 1961. Angel Fund is sub-category of Ventures Capital Fund under Category-I Alternative Investment Fund (AIF), therefore [it is] Entitled to the same exemption, ”Minister of Commerce and Industry Piyush Goyal said in a written reply. However, as an angel investor recently discovered, a weakness in the law means that companies who want to take advantage of this exemption will have to forego many opportunities to use this capital.

Kushal Bhagia, venture capitalist at First Check, pointed out on Twitter: “If your startup has raised angel money, you cannot invest that money in cash – if you do – the angel tax exemption does not apply to you.” Indeed, as of February 19, 2019 Notification in the scoreboard the government says: “A startup is eligible for [an exemption on taxation of angel tax investments] provided it didn’t invest in […] Shares and securities. ” (Highlighting of notifications)

The notice can restrict startups that want to use their funds to acquire stakes in other companies in order to grow quickly. “It’s a topic”, Dhruva Rotti, partner at the tax consultancy Dhruva Advisors called on twitter. He added that a provision in the Angel tax exemption would result in the exemption being lifted retrospectively, potentially turning an earlier exemption into a back tax claim. This arouses the specter of harassment by tax officials, a recurring concern among Indian companies.

The government is trying to calm the harassment, but …

This worry is not exactly new; In the parliamentary reply from Minister of Commerce Goyal, quoted above, the government announced that startups had already been concerned about the issue in meetings. But the government’s somewhat impenetrable response to these concerns doesn’t exactly suggest that the angel investment tax exemption could be lifted if that money was found to have been used to purchase securities. This is what Goyal’s answer said in part:

Several rounds[s] of the discussions were held by the Department for Promotion of Industry & Internal Trade (DPIIT) with the startup ecosystem to address their concerns. Hence there is a notification […] was issued by DPIIT. Central Board of Direct Taxes (CBDT) through their Notification number SO 1131 (E) dated 5NS March 2019 announced that the provisions of Section 56 (2) vii (b) of the Act do not apply to consideration received by a company for the issue of shares that exceed the nominal value of these shares if the consideration is received from a person became a resident of a company that fulfills the conditions set out in notification number GSR 127 (E) of February 19, 2019 of the DPIIT.

The Ministry of Finance had previously announced on Jan.NS December 2018 on the basis of declarations of various startup companies that no coercive measures should be taken to collect the outstanding amount for startup companies if additions were made by the expert pursuant to Section 56 (2) vii (b) of the Income Tax Act 1961 after the amendment / Rejection of valuation under Rule 11 UA (2) of the Income Tax Regulation, 1962. (Emphasis provided)

All that means: We will not bother startups with this exemption if they have bought securities, as long as we had already found out that they should not have been exempted from the outset and have already adjusted our tax assessment. The consequence of this is that if such an exemption has been granted beforehand and is checked later, it can pay a price to the tax authorities.

Effects on the establishment of subsidiaries: Rotti said this “omnibus” restriction even prevented subsidiaries from being set up. “It’s not technically a question of income tax. This needs to be addressed by DPIIT, ”he argued. “In my opinion, DPIIT must provide certain exclusions for this.”

SEBI relaxes regulations

SEBI signaled in March that it would relax regulations on venture capital and angel mutual funds and made the following changes:

  1. SEBI has incorporated the government’s definition of “start-ups” into its fishing and venture capital fund regulations
  2. SEBI also allowed venture funds to invest in previously restricted sectors
  3. It has mandated a code of conduct for VCs and angel investors and the committees that perform the functions in their organizations.
  4. It allowed these funds to invest in shares of other alternative investment funds (AIF) and directly in the securities of associated companies.

Note that while investing in securities in fishing funds is permitted, it does not appear to mean that the money has been invested from Angel funds can be exempt from tax for investments.

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