Angel tax: Are startup M&As at risk?

Are mergers and acquisitions (M&As) and acqui-hires (buying a company to hire talent) in the startup universe likely to be at risk due to the prevailing confusion on norms regarding investments in stocks & securities?

Here’s a quick round-up of the developments:

What has angel tax to do with startup M&As?

A February 2019 notification by the government redefined the norms for what can be considered a startup for exemption from angel tax. 

Angel tax refers to Section 56 (2) (VIIB) of the Income Tax Act that treats early stage investments in startups as income from other sources, taxing it on par with corporate tax rate of 30%. 

Apart from relaxing the upper limit for paid-up capital and turnover for startups to be exempted from corporate taxation of 30% on early stage investments, the notification came up with dos and donts for startups seeking exemption.

The riders were meant to differentiate genuine startups from fraudulent shell companies constituted for tax evasion.

A clause in the notification states that startups claiming exemption cannot trade in shares and securities. 

How does this clause have a bearing on M&A activity of startups?

Depending on the interpretation, the term ‘shares’ can be defined as that of a company the startup is looking to acquire. The term ‘securities’ also excludes any form of mutual fund investment that can be made by the startup to generate returns on the capital raised.

Is there an explicit clause preventing startup M&As?

No, according to legal experts.  “There are no restrictions on the transfer of shares of an eligible start-up,” Lokesh Shah, partner at law firm L&L Partners, told TechCircle. “However, a start-up may not be eligible for the angel tax exemption if it undertakes investment in assets prescribed in the February notification such as shares and securities.” 

Is there a workaround?

Yes. “It may be possible for an eligible start-up to acquire a business (such as by way of a slump purchase), subject to the investment restrictions prescribed in the February notification,” Shah said.

Has there been a request filed by startups seeking clarification?

No. Companies have not approached specific departments seeking clarification on the clause as on date.