How to decide on a suitable mode for angel investing

Investors are increasingly looking for alternative investment opportunities to generate high returns. One such option is angel investing, where individuals invest in startups. Many forums offer startups looking for early-stage funding the opportunity to contact investors directly. Investors must carefully consider factors such as taxation, compliance costs, complexity and flexibility when choosing an appropriate angel investing mode.

It is easiest if the investor invests in his own name. As these are unlisted shares, capital gains at the time of exit are classified as long-term or short-term depending on the holding period of two years or more. Long-term capital gains (LTCG) would be taxed at 20% (plus applicable surcharges and duties) and short-term capital gains (STCG) would be taxed at the applicable flat rate.

The other modes available are investing through a limited liability company or a limited liability partnership (LLP).

A limited liability company would normally earn a similar tax rate on long-term profits, but the short-term profits would be taxed at 25.17%. However, a tax would be levied on the distribution in the form of dividends, which in the hands of investors would be taxed at the applicable flat rates. As such, this may not be a tax-friendly option. It also introduces another complication, as incorporating a company solely for this purpose may entail the application of the Non-Banking Financial Corporations (NBFC) Regulations. Also, in the past, the Reserve Bank of India issued instructions to the Ministry of Corporate Affairs not to allow the formation of such companies.

Accordingly, this option would only be suitable if the person has a company with an existing business, since in this case investment may not be the only activity of this company. From a compliance perspective, this is a costly option as it requires a mandatory audit, multiple annual and periodic filings, etc.

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LLPs are relatively tax friendly. The LTCG tax rate is the same and the STCG tax rate is 30% (plus surcharge and duty). The highest surcharge rate for an LLP is 15% and consequently the highest tax rate would be 35.88%. However, individuals could be subject to the maximum surcharge rate of 37% depending on their tax bracket and therefore the maximum 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 can also cause a stir at RBI. The NBFC rules do not normally apply to an LLP, but the regulatory landscape is unclear as to whether they are permitted for investment-only activities. From a compliance perspective, it makes more sense than a limited liability company.

Additionally, some of the other angel investing forums offer to invest through the Alternate Investment Fund (AIF) mode where they pool money from multiple angel investors and invest in startups. Fundraising via AIF route is beneficial for startups as they can accept funds from multiple angel investors. In other cases, when too many investors show interest, they may have to turn some of them down due to market cap restrictions. As a rule, these are AIFs of category I or II, which have a tax pass-through status. This means that the income generated by the fund will be taxed in the hands of the investors and the taxation will be similar to that of individual investors investing on their own behalf. This mode offers no additional tax incentives, but could help investors not miss out on good startups with cap-table restrictions.

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In addition, there are certain restrictions, e.g. B. you would have to make a minimum investment of 25 lakh in the fund over five years and should have a minimum tangible net worth 2 crore (without primary residence). The collective investment by AIF allows it to remain invested for a longer period of time, unlike individual investors, as they may have to exit during further rounds of funding.

It is also worth noting that investors must declare these accordingly in their tax returns. In the case of direct investment, the investor is required to disclose its holding in the Appendix entitled “General Information” in the table dedicated to the reporting of holdings in unlisted shares. If the investment is made through a limited liability company/LLP, the interests in them will be disclosed by the investor and the interests in startups will be included in the limited liability company/LLP’s tax return. The AIF investment is included in the reporting for assets in the AL schedule.

Sandeep Sehgal is Partner Tax at AKM Global.

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