Home / Money / Personal Finance /  How to decide on a suitable mode for angel investing

Investors are increasingly looking at alternate investment options to earn high returns. One such option is angel investing, wherein individuals invest in startups. Many forums provide opportunities to the startups seeking early-stage funding, to pitch directly to the investors. Investors need to carefully consider factors of taxation, compliance costs, complexity and flexibility while choosing a suitable mode for angel investing.

The simplest way to do so is that the investor 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 upon a period of holding of two years or more. The long-term capital gains (LTCG) would be taxed at 20% (plus applicable surcharge and cess), and short-term capital gains (STCG) will be taxed as per the applicable slab rate.

The other available modes are investing through a Private Limited Company or Limited Liability Partnership (LLP).

A private limited company would ordinarily attract a similar tax rate for long-term gains, but the short-term gains would be taxed at 25.17%. However, there would be a tax on the distribution in the form of dividends, which would be taxed in the hands of the investors at applicable slab rates. Hence, this may not be a tax-friendly option. Besides, this attracts another complication as forming a company for this purpose only may attract the application of Non-Banking Finance Company (NBFC) regulations. Also, there have been instructions in the past by the Reserve Bank of India to the ministry of corporate affairs not to allow incorporation of such entities.

Accordingly, this option would be suitable only if the individual has a company with an existing business as in that case, investing may not be the sole activity carried out by this entity. From a compliance perspective, it is a costly option as it requires a mandatory audit, several annual and periodical filings, etc.

LLPs are relatively tax friendly. LTCG tax rate is the same and STCG will be at 30% (plus surcharge and cess). The highest rate of surcharge for an LLP is 15% and consequently, the highest tax rate would be 35.88%. However, the individuals, depending upon their tax slab, could be subject to the highest rate of surcharge of 37%, and hence the highest tax rate could be as high as 42.75%. The distributions are tax-free in the hands of the LLP partners.

This option could be beneficial for High Net worth Individuals (HNIs). Nevertheless, this too can raise some eyebrows with the RBI. The NBFC regulations are not ordinarily applicable to an LLP but the regulatory landscape is unclear regarding its permissibility for investing activities solely. From a compliance perspective, it is more reasonable than a private limited company.

Furthermore, some of the other angel investing forums offer to invest through the Alternate Investment Fund (AIF) mode, wherein they pool money from several angel investors and invest in startups. Raising funds through 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 to some of them due to market cap restrictions. Ordinarily, these are Category I or Category II AIFs that have a pass-through status as regards to taxation. This means that the income earned by the fund shall be taxed in the hands of the investors and the taxation will be akin to individual investors investing in their own name. This mode does not offer any additional tax incentives but could help the investors not miss out on good startups having cap table restrictions.

Moreover, there are certain restrictions like, one would need to commit a minimum investment of 25 lakh to the fund over five years and should have a tangible net worth of at least 2 crore (excluding principal residence).The collective investment by AIF allows it to remain invested for a longer period as opposed to individual investors as they may have to exit during further rounds of funding.

It is also worth mentioning that the investors will accordingly need to report these in their tax returns. If invested directly, the investor will need to disclose their holding in the ‘General Information’ schedule in the table designated for reporting holdings in unlisted shares. If the investment is through a Private Limited Company/LLP, the holdings in these would be disclosed by the investor and the holdings in startups will be done in the tax return of the Private Limited Company/LLP. The AIF investment will be clubbed in the reporting for Assets in AL Schedule.

Sandeep Sehgal is partner-tax at AKM Global.

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