What is 'Angel Fund'?

“Angel fund” is a sub-category of Venture Capital Fund under Category I Alternative Investment Fund that raises funds from angel investors and invests in accordance with the provisions of Chapter III-A of AIF Regulations. In case of an angel fund, it shall only raise funds by way of issue of units to angel investors.

Angel investor

An angel investor (also known as a private investor, seed investor or angel funder) is a high-net-worth individual who provides financial backing for small start-ups or entrepreneurs, typically in exchange for ownership equity in the company. Often, angel investors are found among an entrepreneur’s family and friends. The funds that angel investors provide may be a one-time investment to help the business get off the ground or an ongoing injection to support and carry the company through its difficult early stages.

•  An angel investor is usually a high-net-worth individual who funds start-ups at the early stages, often with their own money.
•  Angel investing is often the primary source of funding for many start-ups who find it more appealing than other, more predatory, forms of funding.
•  The support that angel investors provide start-ups fosters innovation which translates into economic growth.
•  These types of investments are risky and usually do not represent more than 10% of the angel investor’s portfolio.

Importance of Angel Investors

•  Small businesses are financed through angel investors.
•  They give funding at a time when traditional sources of finance, such as banks and financial institutions, are proving difficult to come by.
•  They foster entrepreneurship in the country in this way.

Angel Investment

Investment, which is made by angel investors, is called Angel Investment. Angel investors generally make an investment in startup companies or new companies establish by entrepreneurs. The main intension behind the investment is not to make a profit but to boost startup growth and new ideas by youngsters. To boost the confidence of startups, angel investors provide lucrative terms as compared to other investors. Recently many startup companies in India have received abundant investment across the globe, which has secured not only startups growth but also economic growth in India.Angel investors who are also referred to as informal investors are individuals having good net worth and are willing to make an investment in the country. These investors include private investors, fundraisers, and business angels, etc. who make investments or inject funds for startups by securing equity in the company.

Regulation 19F: Investment by Angel Funds

1. Angel funds shall invest in venture capital undertakings which:

•  complies with the criteria regarding the age of the venture capital undertaking/startup issued by the Department of Industrial Policy and Promotion under the Ministry of Commerce and Industry, Government of India vide notification no. G.S.R. 180(E) dated February 17, 2016, or such other policy made in this regard which may be in force;]
•  have a turnover of less than 100 crore rupees;
•  are not promoted or sponsored by or related to an industrial group whose group turnover exceeds three hundred crore rupees; and

Explanation I: For the purpose of this clause, “industrial group” shall include a group of body corporates with the same promoter(s)/promoter group, a parent company and its subsidiaries, a group of body corporates in which the same person/ group of persons exercise control and a group of body corporates comprised of associates/subsidiaries/holding companies.Explanation II: For the purpose of this clause, “group turnover” shall mean combined total revenue of the industrial group.

•  are not companies with family connection with any of the angel investors who are investing in the company.

What does an investor look for while funding?

In the context of AIFs, a Fund of Fund is an AIF which invest in another AIF.An AIF under the SEBI (Alternative Investment Funds) Regulations, 2012 can be established or incorporated in the form of a trust or a company or a limited liability partnership or a body corporate. Most of the AIFs registered with SEBI are in trust form.

Venture Capital Funds (VCFs) registered under the repealed SEBI (Venture Capital Funds) Regulations, 1996 ("VCF Regulations") may seek re-registration under SEBI (Alternative Investment Funds) Regulations, 2012 subject to approval of two-third of their investors by value of their investment.As against other applications for registration as Category I- VCFs who have to pay 5 lakhs as registration fees, VCFs registered under the VCF Regulations are required to pay 1,00,000 only as re-registration fees. Venture Capital Funds registered under SEBI (Venture Capital Funds) Regulations, 1996 shall continue to be regulated by the said regulations till the existing fund or scheme managed by the fund is wound up and such funds shall not launch any new scheme after notification of the AIF Regulations. Further, the existing fund or scheme shall not increase the targeted corpus of the fund or scheme after notification of AIF Regulations. However, VCFs may seek re-registration under these regulations subject to approval of two-thirds of their investors by value of their investment.

AIFs are privately pooled investment vehicles. AIFs shall raise funds through private placement by issue of information memorandum or placement memorandum, by whatever name called. As an eligibility criterion for registration as an AIF, the applicant is required to be prohibited by its memorandum and articles of association/ trust deed/ partnership deed from making an invitation or solicitation to the public to subscribe to its securities.

In case the AIF is a trust, the CTR shall be submitted to the trustee and sponsor within 30 days from the end of the financial year.

In case of other AIFs, the CTR shall be submitted to the sponsor within 30 days from the end of the financial year.

In case of any observations/comments on the CTR, the trustee/sponsor shall intimate the same to the manager within 30 days from the receipt of the CTR. Within 15 days from the date of receipt of such observations/comments, the manager shall make necessary changes in the CTR, as may be required, and submit its reply to the trustee/sponsor.

In case any violation of AIF Regulations or circulars issued thereunder is observed by the trustee/ sponsor, the same shall be intimated to SEBI as soon as possible.

Overseas investments by AIFs investments shall not exceed 25% of the investible funds of the scheme of the AIF subject to overall limit of USD 500 million (combined limit for AIFs and Venture Capital Funds registered under the SEBI (Venture Capital Funds) Regulations, 1996).

Procedure for winding up of AIF

In terms of Regulation 11(2), information memorandum or placement memorandum issued by an AIF shall inter alia include information on manner of winding up of the Alternative Investment Fund or the scheme. In terms of Regulation 29 of AIF Regulations, an Alternative Investment Fund shall be wound up:

•  when the tenure of the Alternative Investment Fund or all schemes launched by the Alternative Investment Fund, as mentioned in the placement memorandum is over; or
•  if seventy five percent of the investors by value of their investment in the Alternative Investment Fund pass a resolution at a meeting of unit-holders that the Alternative Investment Fund be wound up; or
•  In case of a trust, if it is the opinion of the trustees or the trustee company, as the case may be, that the Alternative Investment Fund be wound up in the interests of investors in the units; or
•  if the Board so directs in the interests of investors.

The trustees or trustee company or the Board of Directors or designated partners of the Alternative Investment Fund, as the case maybe, shall intimate the Board and investors of the circumstances leading to the winding up of the Alternative Investment Fund. On and from the date of such intimation, no further investments shall be made on behalf of the Alternative Investment Fund so wound up.

Over the last five years, India has seen an inflow of $250 billion of foreign direct investment. Out of the total, almost 75 per cent of this FDI, i.e. $184 billion, has come in through venture capital and private equity funding, which invests in the unlisted companies, start-ups, and growth companies, leading to the creation of unicorns. While this unprecedented surge in FDI can partly be viewed as a means to avoid any implication of angel tax (because of the restrictive covenants), it can additionally be attributed to the liberalized regulatory environment for foreign investments in start-ups and the promising business models of young Indian entrepreneurs. The impact of the investment by the non-resident investors is that the majority of these start-ups are forced to have their holding company outside India, to limit the exposure to the Indian laws.

Way Forward

As of May 2021, there were over 50 unicorn start-ups in India, with valuations exceeding $1 billion (approx. 7200 crore). The success story of some of the startup unicorns of fund-raising might overshadow the issue but in the initial stages of the startups, it’s the resident investors who invest in and help them in graduating to the next level, where after, the Venture Capital investors and private equity investors, storm into the limelight with their big bang investments.

Angel tax is imposed only on investments made by a resident investor. It should be noted that angel tax is not applicable in case the investments are made by any non-resident or venture capital funds.

Angel Tax is a tax levied by the government on start-ups who are funded by angel investment. As mentioned earlier, Angel Investment is the investment made by an Angel Investor. They recognize crude talent and if it fits their demands, Angel investors agree to invest in them. According to the laws of India, all start-ups who receive investment from an angel investor have to pay a certain percentage of the investment to the government.

The law under which Angel Tax comes states that the start-up needs to pay a certain part of the investment to them if the total investment value is greater than the Fair Market Value (FMV). The basis of Angel tax is that the extra investment that the start-up receives is seen as an income. And thus, according to the Income Tax rules of India, a start-up is liable to pay the Angel tax as a part of Income Tax.

•  Only payments made by Indian Residents are liable for Angel tax. This means that if a start-up is funded by a resident Indian, then the start-up has to pay a certain share of this investment in the form of angel tax.
•  Since Angel tax demands start-ups to share a piece of their investment, some of their money is being lost in the form of tax. Most start-ups need a strong financial basis, to begin with, and Angel Tax seems to take a huge toll on start-ups while Investments made by non-resident investors and venture capitalists are not liable for Angel Tax deduction.
•  Since Angel tax has caused a lot of problems to start-ups as they were losing a huge sum of their investment in the form of tax. This activity not only affects to start-up but also affects the investor. Seeing the unhealthy effects of Angel tax, people were trying to find grounds for exemptions. The government has finally notified the start-ups that there are conditions under which exemption is possible. This comes under Section 56 of Income Tax Law, 1961.

Hence, as an investor, you are losing one third of the value of your investment immediately. This is the story that has been playing out in the last few months in the tax department, with the tax authorities levying income tax on various capital infusions by investors into companies.
There are two provisions under which such additions are being made.

In the meanwhile, the Central Board of Direct Taxes has clarified that no coercive action will be taken to recover tax demanded on account of rejection of valuation. But, this is not sufficient, as the tax demands have to be challenged in appeal. Further, the central government has promised to do something to address the situation.

Besides losing a huge chunk of investment to the government, there are many factors which come into play. These factors adversely affect the true potential of a start-up. Some of these factors are:

The difference in calculation of Market Value

It has been observed that there is a significant difference in the methods of calculation of true market value. The approach that the government takes when calculating the market value of a start-up is way different from the approach taken by the start-up.

Many factors are considered when a company calculates its market value. The same factors are not considered when the government calculates the net worth of a start-up. Many factors which elevate the market value of a start-up are ignored by the government and this in an unbelievably low market value.

On the other hand, Angel investors who make an investment consider the true potential of the company while making an investment. They know, if nurtured properly, a start-up can yield a lot. Hence, they invest a lot. This extra investment is seen in the form of income and is charged for tax, whereas this sum of money can be used by the company.

Therefore, ever since its introduction, the tax came under criticism by investors, industry analysts and entrepreneurs for being cumbersome and startup unfriendly. They said that calculating a startup’s fair market value had subjective aspects to it which could not be standardized since a startup’s valuation may be based on something as simple as projected returns at a given point and are subject to negotiations between the startup and investor. Another problem was, assessing officer, a key tax official who scrutinizes the books, would choose cash discounted flow to determine the fair market value, which was not a very favorable practice for startups. In December 2018, more than 2000 startups received tax notices to pay up dues on the angel tax, including penalty charges.

There are many reasons due to which startups are opposing this concept of angel taxation along with investors as investors are reluctant to invest in Indian startups due to this concept, which impose higher tax amount on them. Certain reasons are as mentioned below:

•  There is a difference in the method of calculation of market value shares as used by companies from the concept as used by government authorities. Government authorities don’t use many factors while calculating the market value as include by many startups, which results in a much lower value. This calculation result done by startups results in higher price value, which leads them to make a huge investment in the companies. But this difference in calculation later leads to payment of a large amount of tax amount.
•  Due to large amount of taxation to be paid, many investors are avoiding making an investment in the market which has a huge impact on Indian industries as many large investors are avoiding funding due to the reason
•  Angel taxation has halted the development and growth of startups, leaving them disheartened.

After huge opposition by startups and many investors, finally Indian government has come up with certain changes that have further a positive hope in this direction.

What are initiatives taken by the government in this regard?

In order to promote the startup industry, the government has taken certain steps in regards to angel taxation as mentioned:

• Earlier, a company was regarded as a startup for a period of 7 years from the date of its incorporation. But now it has been increased to 10 years in order to provide benefits in terms of income tax for a further three years.

• Further, a company shall be regarded as a startup if it has not attained a turnover of more than 100 crores for the said financial year. This limit was 25 crores before, which has now been increased.
• In the case said entities meet the criteria as defined by the government, then exemption from angel taxation shall be given.

Startup would mean any innovative entity that uses technology and is less than 10 years of age. This entity should not have clocked 100 crore in turnovers for any year.

If a startup has 25 crore in each year, it would still be a startup but if a startup has 100 crore in even one year, it would not be considered a startup.

Exemption:

• Whatever money you raise, will be exempt till total Share capital plus share premium touches 25 crore. This means that the total amount of capital issued, should be below 25 crore.
• This means an exempt startup will not have to pay any angel tax for upto 25 crore of capital raised. This can be in multiple tranches. A startup can raise 10 crore and then 5 crore and then 6 crore and all of it would be free from angel tax.
• However if a startup already has paid up share capital of 20 crore, even if a startup raises 8 crore, it shall not be eligible for the exemption.

Inclusion:

In order to calculate the above mentioned 25 Crore, the amount of money received from the following will not be included

Prohibition:

In order to check that the company that has received investment is not a shell company, the startup cannot invest in any of the following assets

A Startup shall be eligible for exemption subject to the following conditions

1. It has been recognized by DPIIT as an eligible Startup
2. Aggregate amount of paid-up share capital and share premium of the startup after issue or proposed issue of a share, if any, does not exceed, 25 Crore rupees:

In computing the aggregate amount of paid-up share capital, the amount of paid-up share capital and share premium of twenty-five crore rupees in respect of shares issued to any of the following persons shall not be included

• a non-resident
• a venture capital company or a venture capital fund
• a specified company” means a company whose shares are frequently traded within the meaning of Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 and whose net worth on the last date of the financial year preceding the year in which shares are issued exceeds one hundred crore rupees or turnover for the financial year preceding the year in which shares are issued exceeds two hundred fifty crore rupees.

1. Startup shall not invest in any of the assets given below for the period of seven years from the end of the latest financial year in which shares are issued at a premium

• a building or land appurtenant thereto, being a residential house, other than that used by the Startup for the purposes of renting or held by it as stock-in-trade, in the ordinary course of business
• land or building, or both, not being a residential house, other than that occupied by the Startup for its business or used by it for purposes of renting or held by it as stock-in-trade, in the ordinary course of business;
• loans and advances, other than loans or advances extended in the ordinary course of business by the Startup where the lending of money is a substantial part of its business

However, in order to qualify for angel tax exemption, the startup should meet certain criteria which are as follows:

• The paid-up capital and share premium of the startup should not exceed 10 crore after issuing shares.
• The startup should procure the fair market value certified by a merchant banker.
• The investor should have a minimum net worth of 2 crores and the average income in the last 3 financial years should not be less than 50 lakh.
• The startup should have received approval from an 8 member inter-ministerial board for angel tax exemption.
• In order to simplify the compliance procedure, the government in a recent notification has done away with the requirements fair market value certificate issued by a merchant banker and approval from an inter-ministerial board. The eligible startup can simply request angel tax exemption from the Department of Industrial Policy & Promotion (DIPP) with applicable supporting documents. The application of DIPP-recognized startups will be forwarded to CBDT (Central Board of Direct Taxes) along with the attached documents. CBDT has been mandated to accept or decline such an application within 45 days from the day of receipt.

1. Companies need to be registered with the government as start-ups to make use of the latest exemption. To start with, only DPIIT-recognized startups have been spared from the Angel Tax, but MSMEs and SMEs operating from rural areas may not have the means to complete the documentation process and are still facing challenges.
2. Secondly, eligibility for tax exemption is not applicable for startups that invest the capital received from investments in immovable properties like lands and buildings, and loans and advances, contribution made to other entities, jewellery, artefacts, or any mode of transport where the actual cost exceeds 10 lakh (aircraft, car etc.) – if purchased or traded for any purpose other than that regarding the ordinary course of business. This means early-stage and bootstrapped startups in sectors such as deep tech may face difficulties while raising funds.To be classified as a startup, a company has to prove certain conditions such as that it hasn’t invested in vehicles worth more than 10 lakh, in land unrelated to the business, or in jewellery.
3. Startups that invest in shares and securities are also not eligible for Angle Tax exemption. Since most new ventures tend to invest in debt mutual funds to multiply their fund, this hinders their growth. Moreover, startups with overseas ties or foreign subsidiaries are barred from making a capital contribution to any entity. This again creates obstacles for companies that operate in certain sectors and require liaisons with other firms to sustain long-term growth.
4. Another aspect that has caused alarm among the stakeholders in the Indian startup ecosystem is the tax on capital gains. According to sections 111A and 112A of the Income Tax Act, listed equity investments are taxed at 11.9%. However, gains from startup investments are taxed at a much higher rate of 28.5%. While registered VCs and alternative investment funds in the AIF–I category are exempt from the clauses, such discrepancy can deter angel investors from investing their money into startups. That’s because the extremely high tax on capital gains usually slows down the exit process, taking more years than usual for investors to get paid.
5. These conditions, which are probably intended to prevent money-laundering, can lead to a lot of bureaucratic delays as well as rent-seeking.

(1).Exemption from levy of angel tax under section 56(2)(vii b)

Angel tax is the tax charged on the company, not being a company in which the public are substantially interested, when it issues shares to a resident person at a price which is more than its fair market value. When this provision is triggered, the aggregate consideration received from issue of shares as exceeds its fair market value is charged to tax under the head ‘Income from other sources’ under section 56(2)(viib).
Provided that this clause shall not apply where the consideration for issue of shares is received-

• By a venture capital undertaking from a venture capital company or a venture capital fund or a specified fund; or
• By a company from a class or classes of persons as may be notified by the Central Government in this behalf;
• If such a company receives an excess premium in case of issue of shares to a non-resident, the tax implications of section 56(2) (viib) will not come into play.

In other words, the private limited companies in India should ensure that they issue shares to any other person resident in India at its Fair Market Value (FMV) which may be determined using the Net Asset Value Method or Discounted Cash Flow Method or any other prescribed method. In case, the shares are issued by them at a price in excess of the FMV, the implications of section 56(2) (viib) will get triggered and the company shall be liable to pay tax on such excess premium received by it.

The main reason for the introduction of the ‘Angel Tax’ was to tax the excessive share premium received over and above the FMV by the private companies, which was extensively being used as a mechanism for accounting for unaccounted money or black money. Thus, this is one of the anti-abuse provisions introduced to prevent money laundering.

Therefore, if you are a start-up and you are registered with DPIIT & your capital including premium does not exceed 25 crores, you are eligible for exemption from Angel Tax.

An eligible start-up shall get exemption from Angel Tax as given u/s 56(2) (viib). However, the exemption is provided subject to the condition that the start-up should not invest, within 7 years from the end of the latest financial year in which the shares are issued at a premium, in any of the following:

1. The income tax relief impacts the start-ups which are approved by the inter-ministerial panel, where the paid-up capital and share premium of the beneficiary company doesn’t exceed 10 crore after the issuing of shares. This notification is effective retrospectively from 11^th April 2018.
2. Angel investors planning to subscribe shares in a start-up would require fulfilling specified criteria and the start-ups would need to procure the report from the Merchant Banker or Chartered Accountants which would specify the fair market value of such shares as per the income tax rules.
3. As per the income tax notification, angel investors with the minimum net worth of 2 crore or the average returned the income of more than 25 lakhs in the previous 3 financial years will be eligible for 100 % tax exemption on the investments that are made in the start-ups above the fair market value.
4. Many start-ups have raised their concerns over taxation of the angel funds under the provisions laid down under Section 56 of the Income Tax Act, 1961. This section required taxing the funds received by an entity. Around 18 start-ups received the notices from income tax authorities.Start-ups that are incorporated on or before April 2016 could seek the exemptions from this section.
5. However, the 3-year income tax concession is available to the start-ups that have been incorporated after 1^st April 2016. Start-ups enjoy the income tax benefit for 3 out of 7 successive AYs (assessment years) under the Income Tax Act.
6. The Indian government so far has extended the tax benefits to only 88 start-ups which have been recognized by Department of Industrial Policy and Promotion since January 2016. For availing both the concessions i.e. exemption from tax on funds and exemption of tax from 3 years, start-ups need to approach the inter-ministerial board of certification.

100% Profit Exemption to eligible Start-up entities under Section 80-IAC: Deduction at the rate of 100% of its profits and gains is allowed to an eligible start-up for 3 consecutive assessment years out of the 7 years (10 years from 01.04.2020) beginning from the year of incorporation.

The provision of Section 79 of the Income Tax Act doesn’t apply under the following cases:

1. When the change in voting power and shareholding takes place in a previous year on account of the death of the shareholder.
2. When the change in voting power and shareholding takes place in a previous year on account of share transfer resulted due to gift to any relative of the shareholder making such gift.
3. In case of a change in shareholding of an Indian company (being a subsidiary of a foreign company) due to demerger or amalgamation of a foreign company. The demerger or amalgamation is undertaken with the condition that 51% shareholding of amalgamating or demerged foreign company would continue to be the shareholders of the amalgamated or the resulting foreign company.
4. When the change in shareholding takes place based on a resolution plan which is approved under the Insolvency and Bankruptcy Code.
5. When the company and it is subsidiary (including a subsidiary of such subsidiary) in case:

• The Tribunal (on application under Section 241) has suspended the Board of Directors of the company and has appointed new directors; and
• Change in shareholding of the company and its subsidiary (including a subsidiary of such subsidiary) on the basis of resolution plan approved by the tribunal under Section 242 of the companies act.

Exemption of Long term Capital Gain Tax on Transfer of Residential Property if Net Consideration is invested in the Equity Shares of a new Start-up SME Company- As per section 54GB, any capital gain arising to an individual or HUF from the transfer of a long-term capital asset being a residential property (a house or plot of land) shall be exempt proportionate to the net consideration price so invested in the subscription of equity shares of a eligible company incorporated on or after the 1^st day of April, 2016 but before the 1^st day of April, 2019 and turnover of its business does not exceed twenty-five crore rupees in any of the previous years (new Start-up SME Company) before the due date of furnishing the return of income under section 139(1).

If the amount of net consideration which has been received by the company for the issue of equity shares by the individual or HUF is not utilized by the company for the purchase of a new asset (eligible plant and machinery) before the due date of furnishing the return of income under section 139, the unutilized amount should be deposited before the said due date under a deposit scheme, notified by the Central Government in this behalf and the return furnished by the assessee shall be accompanied by proof of such deposit having been made.The amount so utilized and the amount so deposited in the deposit scheme shall be deemed to be the cost of a new asset (eligible plant and machinery).

Where the amount so deposited in deposit scheme is not utilized, wholly or partly for the purchase of new asset within a period of one year from the date of subscription in equity shares by the individual or HUF, then the difference between:

• the exemption allowed under section 54GB earlier; And
• the exemption that should have been allowed based on the amount actually utilized, in the purchase of new asset (eligible plant and machinery)

shall be taxable as long-term capital gain in the hands of individual or HUF in which the period of one year from the date of subscription in equity share by the assessee expires and the company shall be entitled to withdraw such amount in accordance with the scheme.

Thus, if an individual or HUF sells a residential property and invests the capital gains to subscribe the 50% or more equity shares of the eligible startups, then tax on long term capital will be exempt provided that such shares are not sold or transferred within 5 years from the date of its acquisition. The startups shall also use the amount invested to purchase assets and should not transfer asset purchased within 5 years from the date of its purchase.

Section 54 EE of the Income Tax Act applicable for the eligible startups to exempt their tax on a long-term capital gain if such a long-term capital gain or a part thereof is invested in a fund notified by the Central Government within a period of six months from the date of transfer of the asset.

The maximum amount that can be invested in the long-term specified asset is 50 lakhs. Such amount shall be remains invested in the specified fund for a period of 3 years. If withdrawn before 3 years, then the exemption will be revoked in the year in which money is withdrawn.Eligibility for Startup India
As per the Startup India Action plan, the followings conditions must be fulfilled in order to be eligible as Startup:

• Has not yet completed a period of ten years from the date of incorporation/registration.
• Is a private limited company or registered as a partnership firm or a limited liability partnership.
• Has an annual turnover not exceeding 100 crore for any of the financial years since incorporation/registration.
• Is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.
• It is not formed by splitting up or reconstructing a business already in existence.