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Government to make changes in section 56(2) of Income Tax Act in a bid to promote startups
June, 21st 2016

The government has removed the so-called 'angel tax' for investors providing funding to startups under its ambitious plan to boost entrepreneurship and job creation in the country.

Funding to startups, notified under the government-approved plan announced by PM Narendra Modi in January, will not face tax even if it exceeds the face value.

Resident angel investors, domestic family offices or domestic funds which were not registered as venture capital funds can now heave a sigh of relief and not worry about the invested amount getting taxed. Under existing rules, funds raised by an unlisted company through equity issuance are covered under this tax to the extent the amount is in excess of the fair market value.

Such extra inflow is taxable as "income from other sources" under Section 56(2) of the Income-Tax Act and charged the corporate tax rate, resulting in an effective tax of over 30%. The venture capital industry has been lobbying for removal of this tax, terming it a big deterrent to investments.

In many cases, the valuation of startups is far in excess of market value as it is based on the promise of the idea and not the immediate worth. In such a case, the startup would end up losing a chunk of the inflow to this 'angel tax'. The Central Board of Direct Taxes has issued a notification to this effect, exempting startups raising investments from the rigours of Section 56(2)(viib).

"This has been long awaited and is a very welcome step. The abolition of this so-called 'angel tax' has been a long-standing demand of the industry," said Amit Maheshwari, partner, Ashok Maheshwary &Associates LLP. However, earlier investments can still be questioned by tax officers as being overvalued in the light of declining valuations globally and in India, he said.

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