Angel Tax Under Section 56(2)(viib): How Startups Can Defend an Old-Year Notice

Angel tax is the popular name for the tax levied under Section 56(2)(viib) of the Income-tax Act, 1961 on a closely held company wherein shares are issued at a price exceeding their fair market value. The excess so received was taxed in the hands of the company under the head "Income from other sources", even though the amount was in substance capital brought in by the investor.

Take the case of a Gurugram based startup which raised Rs. 2 crore in FY 2021-22 by allotting equity shares of face value Rs. 10 at Rs. 500 per share. The premium works out to Rs. 1.96 crore. In 2026 the company receives a notice on the income tax portal asking it to show cause as to why the said premium should not be added to its income. Many founders in this position are under the impression that angel tax was abolished in 2024 and the notice is therefore not valid, which is not correct.

Is Angel Tax Still Applicable in 2026?

It is pertinent to note that the omission of Section 56(2)(viib) vide the Finance (No. 2) Act, 2024 is prospective in nature. The amendment applies w.e.f. 1st April 2025 i.e. from AY 2025-26 onwards. Share premium received in FY 2023-24 or any earlier year therefore continues to be governed by the provision as it stood at the relevant time, and the Assessing Officer can examine such share issues in a pending scrutiny assessment or by way of reopening under Section 148, subject to the time limits under Section 149. The Income-tax Act, 2025, applicable from tax year 2026-27, does not contain any corresponding provision.

Scope of the Provision Over the Years

The provision was introduced vide the Finance Act, 2012 with the object of checking the routing of unaccounted money through inflated share premium. As originally enacted, it applied only where the consideration was received from a resident. The Finance Act, 2023 removed the words "being a resident", as a result of which premium received from non-resident investors in FY 2023-24 also came within its ambit. For FY 2024-25 onwards, no share issue is covered.

Who Can Still Receive a Notice

A company which had issued shares at a premium in any of the years up to FY 2023-24 may still be issued a notice, provided that year is either pending in scrutiny or can be reopened within the time limits prescribed. The exposure also continues for companies where the assessment has already been completed with a demand of tax, interest and penalty, and for companies which are presently going through investor due diligence wherein the open year is likely to be flagged by the investor's advisors.

Defences Available to the Assessee

The valuation report under Rule 11UA is generally the first line of defence. As per the said rule, the fair market value of unquoted equity shares could be determined either as per the Net Asset Value method or as per the Discounted Free Cash Flow method, at the option of the assessee, and where the DCF method was adopted, the report was required to be obtained from a SEBI registered Category I merchant banker. In respect of non-resident investors, further methods such as the comparable company multiple method were subsequently notified. It is also to be ensured that the report was dated within the period permitted by the rules prior to the date of issue, as a report which is too old is often rejected on that ground alone.

The Assessing Officer, in a large number of cases, has rejected the DCF valuation on the ground that the projections were not achieved in the subsequent years. This approach has not found favour with the courts. It has been held by the Hon'ble Bombay High Court in the case of Vodafone M-Pesa Ltd. vs. PCIT (2018) that the Assessing Officer cannot reject the method of valuation chosen by the assessee, though he can scrutinise the valuation itself, and the projections are to be judged on the basis of information which was available on the date of valuation and not with the benefit of hindsight. Board approved projections, the market data relied upon and the contemporaneous working papers therefore carry considerable weight before the appellate authorities.

Startups recognised by the Department for Promotion of Industry and Internal Trade (DPIIT) were granted exemption from the provision subject to certain conditions, which inter alia included filing of a declaration in the prescribed form, a cap on the aggregate paid up capital and share premium, and a restriction on investment in specified assets such as land and building, loans and advances and motor vehicles. It may be noted that where the company had invested in such assets within seven years from the end of the year of issue, the exemption was liable to be withdrawn for the original year itself. Where the declaration was duly filed and the conditions were complied with, the addition is not sustainable in law.

The category and residential status of the investor is the next aspect to be examined. Consideration received from a venture capital fund, from certain notified classes of investors, and up to 31st March 2023 from non-residents, was outside the scope of the provision altogether. The status of each investor on the date of allotment is therefore required to be verified, since for instance the premium received from a non-resident investor in FY 2022-23 cannot be brought to tax under Section 56(2)(viib) at all.

In a large number of cases the Assessing Officer, apart from Section 56(2)(viib), also invokes Section 68 and treats the share capital and premium as unexplained cash credit, which is taxable at the higher rate under Section 115BBE, and in such cases the Hon'ble Supreme Court in PCIT vs. NRA Iron & Steel Pvt. Ltd. (2019) has held that the onus lies on the assessee company to establish the identity of the share applicant, his creditworthiness and the genuineness of the transaction, more so where the shares have been issued at a high premium to persons having no apparent means. The corresponding provision under the Income-tax Act, 2025 is Section 102, however for the years in question Section 68 continues to apply. The primary onus is generally discharged by furnishing the PAN, income tax returns and bank statements of the share applicants alongwith the share application forms and Form PAS-3 filed with the ROC, and in case of foreign investors the FIRC and Form FC-GPR, whereafter the burden shifts on the Assessing Officer to bring on record material to the contrary.

Where the notice has been issued for an old year, the validity of the reopening is to be examined before going into the merits of the addition. The time limit, the sanction of the specified authority and compliance with the procedure laid down under Section 148A are to be checked. Since share premium is recorded as an entry in the books of account, reopening beyond three years is permissible only where the income escaping assessment is Rs. 50 lakh or more and the notice has been issued within the outer time limit. A reopening which fails on any of these counts is bad in law and the entire proceedings are liable to be quashed.

It is also a settled position that the same amount cannot be added both under Section 56(2)(viib) and under Section 68 in respect of the same issue of shares. The assessment order should be examined carefully for any such overlapping addition and the issue should be specifically raised in the grounds of the first appeal.

Read More: Section 148A Notice: How to Reply and Stop Reassessment

Steps to be Taken on Receipt of the Notice

As regards the procedure, on receipt of a notice the assessee ought to first ascertain the assessment year involved, the provision under which the notice has been issued and the amount sought to be added, inasmuch as the approach in a scrutiny under Section 143(2) is quite different from that in a reassessment under Section 147. The valuation report, the board and shareholder resolutions, the documents of the investors and the ROC filings of the relevant year are thereafter required to be retrieved, which in many cases are lying with the earlier consultant or the company secretary who had handled the allotment. It is advisable that where the valuation report appears weak, an independent opinion be obtained before the reply is filed, since a report once relied upon in the reply becomes difficult to improve upon at the appellate stage. The reply, alongwith the documents and a proper explanation, is to be filed on the portal within time or an adjournment sought in writing, and a personal hearing through video conferencing may be requested therein. In the event the order is adverse, the remedy lies by way of appeal before the CIT(A) and thereafter the ITAT, and an application for stay of demand under Section 220(6) may be moved where recovery is apprehended.

Also Read: Faceless Assessments and Appeals Under the Income Tax Act, Filing the First Appeal Before the CIT(A) and Stay of Demand Under Section 220(6)

Common Mistakes

The mistake most frequently noticed in these matters is that a brief reply is filed without the valuation report, the investor documents and the bank trail, on the assumption that the Assessing Officer would call for the same subsequently, which in a faceless assessment more often than not does not happen and the order gets passed on the basis of whatever is on record. Reliance on a valuation report which is dated much prior to the allotment, or which is based on projections that the present management is not in a position to explain, also weakens the case considerably, as does the tendency to address only Section 56(2)(viib) while overlooking the exposure under Section 68, which in our view is often the larger issue. There is also a fairly widespread impression that the omission of the provision in 2024 has put an end to the earlier years as well, which is not the legal position, and similarly the certificate obtained for FEMA purposes cannot by itself be relied upon, the pricing guidelines under FEMA and the valuation rules under the Income-tax Act being different.

Disclaimer: The contents of this article are for general information only.