Investors are increasingly looking at alternative investment options to earn higher returns. One such option is angel investing, in which individuals invest in startups. Many forums provide opportunities for startups seeking early-stage funding, to pitch directly to investors. Investors need to carefully consider the factors of taxation, compliance cost, complexity and flexibility while selecting the appropriate mode for angel investing.
The easiest way to do this is for investors to invest in their own name. Since these are unlisted shares, the capital gains at the time of exit will be classified as long term or short term depending on the duration of two years or more. Long-term capital gains (LTCG) will be taxed at 20% (plus applicable surcharges and cess), and short-term capital gains (STCG) will be taxed at the applicable slab rate.
Other available methods are investing through a Private Limited Company or Limited Liability Partnership (LLP).
A private limited company usually attracts the same tax rate for long-term profits, but short-term gains will be taxed at 25.17%. However, there will be a tax on distribution in the form of dividend, which will be levied at the applicable slab rates in the hands of the investors. Hence, it may not be a tax-friendly option. Further, it attracts a further complication as forming a company for this purpose can only attract the application of Non-Banking Finance Company (NBFC) rules. Also, the Ministry of Corporate Affairs has been directed by the Reserve Bank of India not to allow such entities to be incorporated in the past.
Accordingly, this option would be suitable only if the individual is holding a company with an existing business, as in that case, investment may not be the only activity undertaken by this entity. From a compliance point of view, this is a costly option as it requires a mandatory audit, multiple annual and periodic filings, etc.
LLPs are relatively tax friendly. LTCG tax rate is same and STCG will be 30% (plus surcharge and cess). The highest rate of surcharge for LLP is 15% and as a result, the highest tax rate will be 35.88%. However, individuals, depending on their tax slab, may be subject to the highest rate of surcharge of 37%, and hence the highest tax rate can be as high as 42.75%. Distributions in the hands of LLP partners are tax-free.
This option can be beneficial for High Net Worth Individuals (HNIs). Still, this too may raise some eyebrows with the RBI. NBFC regulations are generally not applicable to LLPs, but the regulatory landscape is not entirely clear about its permission for investment activities. From the point of view of compliance, it is more reasonable than that of a private limited company.
In addition, some other angel investment platforms offer to invest through Alternative Investment Fund (AIF) mode, in which they pool money from multiple angel investors and invest in startups. Raising funds through the AIF route is beneficial for startups as they can accept funds from multiple angel investors. In other cases, if too many investors show interest, they may have to refuse some of them due to market cap restrictions. Generally, these are Category I or Category II AIFs that have a pass-through status with respect to taxation. This means that the income earned by the fund will be taxed in the hands of the investors and the taxation will be the same as making investments in the name of individual investors. This mode does not offer any additional tax incentives, but can help investors not to miss out on good startups with cap table restrictions.
Also, there are some restrictions like, one would need to make a minimum investment 25 lakhs over five years and must have an actual net worth of at least 2 crore (excluding domicile). Collective investment by an AIF allows it to remain invested for a longer period unlike individual investors as they may have to exit during further rounds of funding.
It’s also worth mentioning that investors will need to report these on their tax returns accordingly. If invested directly, the investor is required to disclose his holdings in the ‘General Information’ schedule in the table specified for reporting of holdings in unlisted shares. If the investment is through a Private Limited Company/LLP, the holding in these will be disclosed by the investor and the holding in Startups will be made in the tax return of the Private Limited Company/LLP. AIF investments will be included in the reporting of assets in the AL Schedule.
Sandeep Sehgal is Partner Tax at AKM Global.
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