In the Union Budget announcement, the government has responded to a big demand from the start-ups industry: Angel Tax.

In her address, finance minister Nirmala Sitharaman said all start-ups booked under the Angel Tax (Section 56(2)(viib) of the Income Tax act), who have submitted all relevant documents and declarations sought by the tax authority will not be pursued any further.

“To resolve the so-called ‘angel tax’ issue, start-ups and their investors who file requisite declarations and provide information in their returns will not be subjected to any kind of scrutiny in respect of valuations of share premiums,” the minister said.

Under Section 56, infamously called the angel tax, the money raised by a start-up from an angel investor is taxed as income at 30 per cent. It does not apply to firms registered as “start-ups” with the government or those raising money from venture capital funds (which come under Alternate Investment Fund Category 1).

The provision, introduced to prevent money laundering through shell companies, has been a back-breaker for start-ups who have had to go from pillar to post explaining their valuations and legitimacy of the source of their funds to tax inspectors.

Over a hundred start-ups have received tax demands under the angel tax clause in the last two years, with some having to shut shop because it spooked their investors or made further fund-raise a challenge. Start-ups have also companied running into a wall explaining their firm’s valuation to tax inspectors and sourcing intricate financial documents from their investors-- demands made by the tax collectors.

To resolve this issue, the government has proposed an e-verification mechanism for securing necessary fillings from start-ups and investors. The idea is to skip altogether any engagement between a start-up and a tax assessing officer, which many had called out as akin to harassment.

In addition, the minister said, special administrative arrangements will be made by Central Board of Direct Taxes (CBDT) for pending assessments of start-ups and redressal of their grievances. “It will be ensured that no inquiry or verification in such cases can be carried out by the Assessing Officer without obtaining approval of his supervisory officer,” she said.

In another big respite, the government said it had decided to exempt category II AIFs from the purview of the angel tax, which was a main recommendation of the investor community. “At present, start-ups are not required to justify fair market value of their shares issued to certain investors including Category-I Alternative Investment Funds (AIF). I propose to extend this benefit to Category-II Alternative Investment Funds also. Therefore, valuation of shares issued to these funds shall be beyond the scope of income tax scrutiny,’ Sitharaman said.

"AIF 2 funds now protected from Angel Tax: wonderful move to support innovation and private investment by @nsitharaman @narendramodi Thanks for your immense faith and encouragement to Indian VC PE investors and investments!" tweeted Gopal Srinivasan‏, chairman and managing director, TVS Capital.

According to data from Indian Venture Capital Association (IVCA) 291 category II AIFs invested Rs900 crore in the first half of 2019, which accounts for 35% of total VC investment in this period.