Presuming Evasion, Punishing Innovation: Rethinking India’s Angel Tax Regime

ABSTARCT

This article conducts a critical legal and policy study of India's angel tax scheme under Section 56(2) (viib) of the Income Tax Act, specifically examining its 2023 extension to non-resident investors. The rule, initially established to mitigate illegitimate capital inflows, has transformed into an instrument of regulatory overreach, disproportionately impacting legitimate early-stage funding. Based on the developments of the law as the statutes, CBDT notifications, and legal judgments, this paper presents a breakdown of the structural defects in the valuation scheme, disparities in the exemption regime, and the constitutional hitches concomitant under Articles 14 and 19(1)(g). It asserts that the regime going on will combine the speculative value of enterprise with income, thereby weakening the faith of investors and holding up inflows of capital that are crucial to the progress of startups. The article suggests scaled-up changes: automatic exemptions to DPIIT-recognised startups, a disclosure-based compliance regime, and valuation safe harbours. It ends up promoting the idea of a shift in the tax paradigm based on suspicion to embrace innovation, predictability in law, and economic freedom.

Introduction:

The Indian startup ecosystem has evolved over the past few years since the mid-2010s, and it is now one that matters to the world. Startup India and regulator-friendly schemes, initiated by the government, have made India the third-largest startup hub in the world. However, the same legislative ecosystem that aims to serve innovation is becoming more and more incompatible with the reasoning of early-stage funding. Perhaps this tension is more patent in the recent growth in cases of the so-called angel tax under Section 56(2) (viib) of the Income Tax Act, 1961.

Angel investment, by design, fuels nascent businesses long before they generate revenue or profits. In such cases, business potential is used as the basis of Valuations in such relying on future business potential, making them inherently speculative and forward-looking. But Section 56(2) (viib), that existed since 2012 to deal with money laundering using premiums paid on shares, casts doubt on just such a capital injection. It imposes a taxation on the margin between the level of share subscription and what is considered as the fair market value of the same in the hands of the recipient company, under the premise of a tax-avoidance agenda. Its application has been contentious, even though this may be justified in intent. The same is the case when applied to startups receiving bona fide early-stage funding.

 The 2023 Union Budget amendments further widened the scope of this tax by including non-resident investors, exposing even foreign venture and angel capital to potential taxation. Even the startups considered under the DPIIT are undergoing a fresh bout of uncertainty, though previously spared. The recent developments of the law, which are characterized by unclear valuation standards, uneven exemptions, and a risk of retroactive application, have caused insecurity to both investors and founders.

This article undertakes a critical examination of the legal and economic consequences of these recent amendments. Through an analysis of statutory changes, CBDT circulars, relevant case law, and comparative international frameworks, it argues that the current regime imposes a disproportionate burden on genuine fundraising. The article concludes by proposing normative reforms aimed at reconciling tax enforcement with entrepreneurial needs, shifting from a presumption of evasion to a presumption of legitimacy.

From Anti-Abuse to Overreach: How Section 56(2) (viib) Targets Startups

Section 56(2) (viib) of the Income Tax Act, 1961, introduced through the Finance Act, 2012, was conceived as an anti-abuse measure to deter the laundering of unaccounted money by closely held companies through the issuance of shares at unjustifiably high premiums. The section requires that where a private firm receives consideration from a resident investor for issuing shares at a value exceeding their fair market value (FMV), it will be taxed as income under other sources on the portion that is above the fair market value.

The implementation of this provision hinges on the computation of FMV as defined under Rule 11UA of the Income Tax Rules, 1962. This rule offers two principal valuation methods: the Net Asset Value (NAV) method, which reflects the book value of assets, and the Discounted Cash Flow (DCF) method, which projects future earnings potential. The NAV method reflects a company’s existing book value, while the DCF method estimates future earnings based on projected cash flows.  The DCF method is primarily used by startups that belong to the category of companies that, in the majority of cases, do not own any tangible assets, yet have a wealth of intellectual property and market potential. cannot be able to take the place of objective reasons to make a penalty Yet, even valuations certified by SEBI-registered merchant bankers are frequently challenged by tax authorities, which makes them the subject of a structural conflict between norms of commercial valuation and bureaucratic discretion.

To mitigate this friction, the government introduced a conditional exemption regime in 2019 through a DPIIT notification. This scheme provides relief to startups that meet some of the eligibility requirements, namely, recognition of DPIIT, investment limits, and investor statements. But this is an exception that is not automatic as well as retroactive, and it does not provide start-ups with much protection against further inquiries. Many companies, though formally compliant, still face uncertainty over whether their valuations will withstand departmental interpretation.

The core ambiguity lies in the definition and applicability of FMV to high-risk, innovation-driven enterprises. By definition, startups are asset-less entities with value attached to distant variables, such as intellectual property, the credibility of the founder, addressable market, and expected growth, which simply do not fit well into existing valuation frameworks. The legal system lacks a logical measure of evaluating such dynamic features. Can the concept of fair market value be applied rigidly to entities whose very value proposition is speculative and evolving?

This tension has been judicially acknowledged in ACIT v. Agro Portfolio Pvt Ltd [(2018) 94 taxmann.com 76 (Delhi - Trib)], where the Tribunal held that valuation is inherently imprecise and that bona fide differences in projections or methodology do not, in themselves, justify tax additions. As long as valuation is made on methods that have been recognised and professional certification, then subjective findings of the Assessing Officer cannot substitute objective grounds for invoking penal tax consequences.

Thus, what began as a provision to combat fictitious capital inflows has, through definitional vagueness and procedural rigidity, morphed into a mechanism of overreach. Section 56(2) (viib) does not make a sensible differentiation between fraudulent capital and true early-stage investing. By so doing, it places compliance costs and litigation risks on precisely those startups that represent the uncertainty and ambition that the government allegedly wants to promote.

The 2023 Expansion: Inclusion of Non-Resident Investors

The Finance Act, 2023, marked a significant shift in the scope of Section 56(2) (viib) by extending its applicability to investments made by non-resident investors. Before the amendment, the provision applied only to capital raised from resident investors; thus, foreign venture capital, angel investors, and institutional investors were not the focus of this anti-abuse regime. This protection was rationalised by the need to maintain a conducive investment environment for global capital inflows into India’s startup sector. However, the 2023 amendment signalled a decisive policy reversal.

The amended language now reads:

“where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident or a non-resident, any consideration for issue of shares...”

This change effectively removes the residency limitation, thereby bringing foreign investors within the ambit of angel tax. The Explanatory Memorandum to the Finance Bill justified the inclusion as part of an effort to ensure consistency and a uniform tax treatment of all investors, stating that the intention was to discourage the misuse of the share premiums regardless of the capital source. The amendment provides a precedent in framing as a way to plug a loophole, an expansion of a measure originally designed to curb domestic abuse, now extended to cross-border capital flows.

This move contradicts the prior regulatory intent, which had carefully carved out exemptions to ensure that foreign capital, especially early-stage, high-risk investment, was not disincentivized. By subjecting non-resident investors to the same FMV scrutiny, the amendment introduces a layer of tax uncertainty to inbound funding. Practically, it means that even bona fide foreign investments may be taxed if the valuation is deemed to exceed FMV by the tax department the actual foreign investments in Indian startups could be taxed, provided that the valuation upheld is viewed to be above FMV as perceived by the department, even without the approval of professional valuation specialists.

The broader legal and economic implications are that startups now face tax exposure not just for domestic angel funding, but also for international capital, undermining investor confidence in an already volatile funding climate. It is especially not in line with India's declared goal to become a global hub of start-ups and innovation. Policy initiatives like Invest India, Startup India, and bilateral dialogues aimed at attracting sovereign and institutional venture capital now stand at odds with a domestic tax regime that treats such capital with suspicion.

In effect, the 2023 amendment shifts the underlying legal posture of Section 56(2) (viib) from one of selective deterrence to universal enforcement, without offering sufficient recalibration to account for the nature of startup valuation or the global venture funding ecosystem. The result is a legal grey area which places early-stage firms in a precarious position, caught between compliance and the need for capital access in a more and more risk-averse tax environment.

CBDT Circulars and the Valuation Maze

Following the 2023 amendment to Section 56(2) (viib), the Central Board of Direct Taxes (CBDT) issued Notification No. 29/2023 dated May 24, 2023, to clarify which categories of non-resident investors would be exempt from the extended angel tax regime. The notification offers a limited safe harbour to particular institutional investors, including Sovereign Wealth Funds, Pension Funds, Portfolio Investors, Banks, and Broad-Based Investment Funds, primarily those governed by institutional oversight or bilateral treaty frameworks. This exemption list, however, excludes individual angel investors, family offices, and venture capital funds that have not registered with the SEBI, a substantial segment of early-stage startup funding. This selective exclusion deepens uncertainty and exposes a wide spectrum of foreign investors to potential tax scrutiny and opens a large portion of the foreign investment fraternity to possible lawsuits.

Even where an exemption exists, startups must still navigate the valuation requirements under Rule 11UA of the Income Tax Rules, 1962. The rule mandates the use of either the Net Asset Value (NAV) method or the Discounted Cash Flow (DCF) method, both requiring certification from a Category-I merchant banker registered with SEBI. Yet these methods are inherently narrow. The NAV method has the flaw that it generally underprices startups that, by their nature, hardly have physical assets in excess. Assuming that the DCF approach is more compatible with the historically higher projection assumptions of early-stage startups, while the DCF method aligns better with forward-looking valuations, it still fails to account for qualitative factors such as founder expertise, brand equity, user growth, or product-market fit—key elements in venture capital decision-making.

In practice, even after obtaining a merchant banker’s certified DCF valuation, startups are not immune to post-facto scrutiny. Assessing Officers often invoke discretionary powers to challenge valuations, especially if projections differ from actual future performance. Such discretionary overrides undermine the credibility of the certification process and the valuation certainty, thus creating compliance costs and the risk of litigation.

This concern was reflected in Vodafone India Services Pvt Ltd v. Union of India [(2014) 361 ITR 531 (Bom)], where the Bombay High Court held that the issuance of shares at a premium is a capital receipt and cannot be taxed as income under the Act. Notably, the court noted that the hypothetical distinction between FMV and issue price is not taxable unless openly stated under the law. In this judgment, it was pointed out that FMV does not fix income unless there is a particular charging provision.

Despite such judicial guidance, the valuation regime under Section 56(2)(viib) continues to function without sufficient administrative safeguards. The absence of objective measures, the absence of ways to take the particularities of startups into account, and the very restricted orientation on unchanging methods lead to a system not take any considerations of the economic realities. Consequently, startups acting in good faith can risk subsequent additions only because of the subjective dissatisfaction of the tax authorities.

In sum, the present valuation framework under the angel tax regime is economically disconnected and procedurally fragile. In place of a special valuation logic unique to venture capital, it exposes startups to a rigid mechanism prone to bureaucratic discretion. Not only does this chill the investment environment, but it also poses the risk of undermining the predictability of regulation, which is key to an effective innovation economy.

Policy Fallout: The Startup Investor Freeze

The expansion of Section 56(2)(viib) to include non-resident investors and the subsequent regulatory ambiguity have had a chilling effect on India's early-stage investment landscape. According to reports by NASSCOM and the Indian Venture Capital Association (IVCA), there has been a marked slowdown in seed-stage and early-growth fundraising in the months following the 2023 amendment. Angel and pre-Series A investments have dropped by a considerable margin in Q3 and Q4 of 2023, with investors attributing the decision to a lack of legal clarity as well as tax liability due to valuations.

Startups operating at the pre-revenue or early-revenue stage—particularly those looking to raise bridge rounds or Series A funding—now face heightened difficulty in justifying valuations that are often based on forward-looking metrics such as user acquisition, technology potential, or projected revenue, rather than present cash flow or book value. The result is a two-fold effect: either the capital is pulled out, or it is sold at depressed terms, necessitating dilution of founders and hampering the long-term value.

The practical repercussions have extended to India’s most promising startups. Reports in media outlets such as Inc42 and The Ken have highlighted how Y Combinator-backed startups and other high-potential ventures have begun exploring redomiciliation to more investor-friendly jurisdictions such as Singapore or Delaware. This outflow is not speculative as legal firms and incubators verify that a few start-ups have restructured their holding abroad to nullify the risk against Section 56(2) (viib). It is mere logic that no founder would be comfortable receiving a tax notice or being involved in a lengthy litigation just because an Assessing Officer is challenging a professionally certified value.

First-hand accounts from startup founders underscore the anxiety that this regime has created. Even the existing start-ups, which were earlier assumed to be exempted, have come under scrutiny, particularly when a certain amount of money was taken in by an unlisted or non-SEBI-registered foreign angel. Law costs, valuation consultancy, and tax advisory fees have risen drastically, with an out-of-balance impact on young firms with low financial capacity. For foreign angel investors, the compliance expectations under India’s opaque tax regime act as a substantial disincentive. In the absence of clear, automatic exemptions, many now prefer to invest in Indian founders operating from more permissive jurisdictions.

This investor's hesitation stands in stark contrast to India’s stated economic policy objectives. Initiatives like Startup India, Invest India, and the creation of GIFT City aim to position the country as a global innovation hub. Yet the taxation of capital inflows at the point of share issuance—rather than taxing realised gains—places India at odds with international best practices. In the United States, Internal Revenue Code §1202 offers tax breaks to angel investors, recognising their risk profile. UK The Enterprise Investment Scheme (EIS) provides incentives to invest at the early stage with large exemptions. Singapore has not only ensured that there is no taxing of share premiums but also co-invests in young-stage startups in order to enhance innovativeness.

India, by contrast, taxes the capital itself, even before any income has been earned—thereby inverting the basic principles of capital taxation. This fundamental misalignment between taxation policy and innovation policy threatens to derail the very ecosystem that India claims to nurture. There is also a danger that the present course of action will lead to the creation of an atmosphere of regulatory mistrust and outward migration of capital, sabotaging the lofty potential of the Indian startup economy internally.

Way Forward: Towards a Startup-Specific Tax Framework

The existing angel tax regime, particularly after the 2023 amendments, has disrupted India’s startup investment climate by conflating capital inflow with taxable income. The law against such abuse by intent has ironically created the involvement of criminal punishment in true innovation, as the above sections show. It needs to be a corrective framework that is based upon economic rationality, but also constitutional and doctrinal coherence.

First, a fundamental recalibration must begin with the automatic exemption of DPIIT-recognised startups, regardless of the investor's residency. The present selective exemption model, dependent on investor category, violates the principle of equal treatment under Article 14 of the Constitution. It discriminates against those of similar position (e.g., foreign angels and unregistered VCs) without a legitimate state goal to support that kind of differentiation. With the carve-out, the regime breaks certainty, the effect is restored by an automatic carve-out of recognised startups, which does not detract from the anti-abuse objective.

Second, the law must embrace the practicalities of startup valuation. Given the inherent uncertainty and forward-looking nature of early-stage companies, a safe harbour valuation range must be introduced, calibrated for pre-revenue and seed-stage businesses. This would assist in diminishing litigation risk and will offer predictability to start-ups, although not preclude the tax authority from challenging willful overvaluations. A parallel presumption in favour of valuations conducted by SEBI-registered merchant bankers under the DCF method must also be codified. When valuation is based on certified professional assessments, the burden must shift onto the tax department to demonstrate clear mala fides before initiating additions.

Equally crucial is the need to end the retrospective chilling effect of the law. The principle of prospectivity in tax legislation, embedded in the doctrine of legitimate expectation and repeatedly upheld by courts (as in K.T. Plantation v. State of Karnataka), necessitates that changes to Section 56(2)(viib) be applied only prospectively. The option of retroactive post-factum verification of the past valuations, which cannot be explained by being ruined by fraud, is contrary to principles of basic fairness and economic due process.

An additional reform worth considering is a structural shift: the conversion of angel tax into a disclosure-based compliance regime rather than a taxing trigger. Similar to Form 3CEB in the regime of transfer pricing, startups may be asked to submit valuation reports and a list of investors to be able to calculate trends by the tax department without on-the-spot imposition of penal taxation. This would maintain transparency and control, and make sure that the capital inflows are not considered as income too early.

Underlying these recommendations is the urgent need to align the tax regime with constitutional protections for economic liberty. As recognised in cases like Vodafone International and reaffirmed in multiple rulings on tax fairness, capital receipts cannot be recharacterized as income absent a specific charge. The very formulation in existence on Section 56(2) (viib) does not balance the right to carry on business in Article 19(1) (g) and gives rise to an afforded atmosphere of regulatory ambush, where the founders of startups are subject to penal effects over pertinent business moves.

Ultimately, India must move from a presumption of evasion to a presumption of enterprise. A startup-specific tax framework, rooted in clarity, non-arbitrariness, and constitutional discipline, is not merely desirable; it is imperative. Only then can India sustain its innovation momentum while preserving investor confidence and legal predictability.

Conclusion

The central tension that underpins India’s angel tax regime is unmistakable: the state’s interest in curbing tax abuse is increasingly at odds with the entrepreneurial energy it claims to promote. The 2023 expansion of Section 56(2)(viib), though facially neutral, erects substantive legal and procedural barriers that deter precisely the kind of risk capital early-stage ventures depend upon. The law will break all logic in the market and constitutional guarantees since, in taxing capital inflow at the point of issue, they will be taxed whether the inflow is commercial or professional in nature and at what valuation.

Startups, already navigating uncertainty in product, market, and operations, now face regulatory unpredictability as an added risk variable. The result is not better compliance but capital flight, valuation fear, and legal paralysis. As this article has shown, the current structure of the angel tax is neither aligned with international practice nor with India’s innovation ambitions.

If left uncorrected, this regime will continue to punish compliance, reward caution, and ultimately threaten India’s global reputation as a startup powerhouse. What is needed is not abandonment of oversight, but its recalibration, grounded in law, reason, and trust. Innovation does not thrive under suspicion; it thrives under certainty.

Author: - Akshat Jain, in case of any queries please contact/write back to us via email to chhavi@khuranaandkhurana.com or at  Khurana & Khurana, Advocates and IP Attorney.

References

1.  Income Tax Act, 1961, Section 56(2)(viib); Income Tax Rules, 1962, Rule 11UA.

2.  Finance Act, 2023 (Budget Amendments to Section 56).

3.  CBDT Notification No. 29/2023, dated May 24, 2023.

4.  DPIIT Notification on Startup Exemptions, Ministry of Commerce & Industry, 2019.

5.  Vodafone India Services Pvt Ltd v. Union of India, (2014) 361 ITR 531 (Bom).

6.  ACIT v. Agro Portfolio Pvt Ltd, (2018) 94 taxmann.com 76 (Delhi - Trib).

7.  K.T. Plantation Pvt Ltd v. State of Karnataka, (2011) 9 SCC 1.