A Guide To Tax Laws For Angel Investors, Startup Founders And VCs

For those engaged in the startup ecosystem, understanding and having knowledge of effective tax strategies is essential to achieving long-term success. The Income Tax Act, 1961 (“Act”) has some critical provisions and amendments that could influence your approach to investing, scaling, or exiting your startup. 

In this article, we’ll explore three important sections—reduced taxation of slump sale, updates to buyback taxation, and the end of the angel tax—that are essential for maximizing startup’s potential and minimising tax liabilities on your investments.

Reduced Capital Gains On Slump Sale 

The Budget 2024 has made slump sale transactions an attractive option for companies, with the tax rate on long-term capital gains reduced to 12.5% from the initial 20%. This significant reduction will lead to increased adoption of slump sales as a M&A Structure under following scenarios:

• When companies need to redeploy cash within the transferor company. 
• Facilitating strategic joint venture structures. 
• Other forms of business restructuring like mergers or demergers. These structures are tax and cash neutral. However, the lengthy approval process from SEBI and NCLT makes slump sale transactions more appealing as they don’t require regulatory approval.

This makes slump sale transactions an efficient and tax-effective way for companies to restructure, making it an increasingly popular choice for business reorganisation and exits.

Replacement Of Sec 115QA (Buyback Taxation Law)

The standard practice for angel investors and venture capital funds typically involves an exit clause in the Shareholders Agreement (SHA), usually set for a period of 3 to 7 years. At the end of this period, companies are required to facilitate an exit for investors, either through a secondary sale or by buying back the shares.

Previously, companies were subject to 20% tax (plus surcharge/ cess) on the difference between the amount paid on buy-back of shares and the amount received by the company on the primary issuance of shares under Section 115QA of the Act. Furthermore, the proceeds from the buyback are tax free in the hands of shareholders under the Sec 10 (34A) of the Act. 

However, under the Finance Act of 2024, the tax burden for buyback has shifted from companies to investors, which will be applicable from October 1. The entire buyback amount will now be taxable to investors under the “Income from Other Sources” (IFOS) category. 

While the Capital loss would be available to the extent of cost of acquisition, they cannot be offset against the income under IFOS, leading to upfronting of taxation through deemed dividend. 

This presents a significant tax challenge for angel investors, who are often high net worth individuals (HNIs) subject to the highest income tax rate of ~40% resulting in an additional tax burden of ~14%. This shift in taxation could discourage the use of buybacks as a viable exit strategy for angel investors and venture capital funds.

Abolishment Of The Angel Tax Provision [section 56(2) (viib)] 

The angel tax, introduced in the 2012 Budget was aimed to curb money laundering but inadvertently became a significant hurdle for startups. High Net Worth Individuals (HNIs) and other investors, known as angel investors, who provided capital to startups often faced taxation on the premium paid over the Fair Market Value (FMV) of shares. This premium was taxed as ‘Income from Other Sources’ at an effective rate of 30.9%, leading to what became known as the ‘Angel Tax.’

Recognising the challenges this posed to the startup ecosystem, the central government abolished the angel tax in the 2024-25 Budget. This move is widely seen as a positive step toward creating a more conducive environment for innovation and investment in India. Abolishment of this tax is expected to bolster the startup ecosystem, enhance investor confidence, and stimulate economic growth by reducing the financial burdens on startups and encouraging greater investment in the sector.

The recent tax reforms in India, such as lower taxes on slump sales and the removal of the angel tax, are reshaping the startup ecosystem. These changes reflect a more dynamic tax environment, requiring startups to be agile and well-informed to thrive in this new landscape.