Naveen Kanojia
The Union government claims to promote the entrepreneurship ecosystem with the launch of initiatives such as Startup India. However, there are stringent tax rules affecting angel investors who come in early with their capital to invest in start-ups literally during their caterpillar days.
While these rules are legacy of the previous government, the angel investors of the country are demanding correction in the angel tax law in the upcoming Union budget.
What is Angel Tax?
The much talked about angel tax was introduced by former finance minister Pranab Mukherjee under the Finance Act 2012 with an aim to keep money laundering in check. It is applicable on the capital raised by start-ups from an individual against the issue of shares in excess of the fair market value. The tax regards capital thus raised in access of the fair price as income from other sources under Section 56 (II) of the Income Tax Act. Currently, angel tax stands more than a massive 30 per cent in India.
Hue and Cry
There are multiple layers of issues reported by start-ups and angel investors against the angel tax. To begin with, there are different rules for different people. The long-term capital gains from th esale of unlisted shares in the hands of non-residents attracts a tax of 10 per cent, whereas it attracts a tax of 20 per cent in the hands of residents. Industry lobby NASSCOM calls it a discriminatory treatment of Indian investors against foreign investors who invest in start-ups.
Secondly, as per the Income Tax Act, the angel tax is a tax applicable on start-ups for the capital they raise in excess of a fair market valuation. However there is no clarity on what can be termed as a fair-value pricing.
The Problem of Definition
According to angel investor and former Infosys honcho Mohandas Pai, the methods of assessing the valuation of start-ups are flawed. There is a mismatch between how investors assess a start-up and how the tax authorities do so.
Essentially, start-ups have no significant revenues or distant profits to boast of. In most of cases, their valuation is purely based on the potential and promise of the idea, the background and competence of the founding team. It is conventionally a matter of negotiation between founders and angel investors.
According to NASSCOM, often one party or the other can get it wrong, but it is simply impossible to create a frozen logic for such investments, be it discounted-cash-flow method or a valuation by merchant bankers, etc.
Owing to this confusion about methodology, since the last one year or so, the Central Board of Direct Taxes has been questioning investors. Multiple start-ups have also been complaining about notices they have received from the tax authorities for the investments raised by them.
The Outrage
Pai, who has invested in multiple start-ups across sectors, recently tagged Union finance minister Arun Jaitley and Prime Minister Narendra Modi on Twitter, stating how the start-ups were being harassed because of multiple angel tax notices.
About 1,120 start-ups have accepted that they received income-tax notices in 2017 in a survey conducted by the community-based social network LocalCircles. Over 2,800 star-ups took part in the survey.
Revati Ashok, an angel investor, took on the policymaker on this issue on Twitter:
Such instances not only harass founders but also reduce the interest of high-net individuals or angel investors who otherwise would have invested in the sector.
President of TiE Silicon Valley and general partner of Monta Vista Capital V Shukla said that the government should get out of the business of certifying what a start-up is:
Moreover, in order to get any tax benefit, a start-up is required to get registered with the Department of Industrial Policy and Promotion. As per the Income Tax Act, an entity will be considered a start-up till five years of incorporation and if its turnover for any financial year had not crossed Rs 25 crore. The company was also supposed to be working on an “innovation”. The industry has however been criticising these prerequisites, stating that such a definition had serious limitations. For example, “innovation” will always be a subjective terminology.
Importance of being Start-Up Angels
According to NASSCOM, complicated tax rules, including angel tax, has already led to a 53 per cent decline in angel funding in the first half of 2017. Interestingly this happened at a time when the early stage funding (next stage of funding after the angel round) grew up by 83 per cent and the growth stage start-ups funding grew by 23 per cent.
Angel investment is a high risk investment stage and is termed as the initial supply of oxygen in companies or at times even in idea-stage start-ups. More importantly, they come at a time when most of the start-ups do not have multiple takers. Their contribution becomes particularly important given the fact that nine out of 10 start-ups fail in India within the first five years of operation, according to a study by the IBM Institute of Business Value.
It is easy to ascertain that the angel investment prominently works as a launchpad for the start-up ecosystem which is a low expectancy area. Any further bottleneck in the early stage of the start-ups increases the chances of the start-ups shutting down their shops sooner. This in turn will further reduce the appetite of the investors to pump in money in early-stage start-ups, thus killing the entrepreneurship ecosystem early on.
In simple words, angel investments are the early-stage encouragement provided to young entrepreneurs and such high tax levied on them is considered to be a huge deterrent to the growth of the start-up sector.
Start-Ups back Angel Investors
The issue has led to a group of entrepreneurs launching an online petition on Change.org against the tax. The petition, which has already been signed by start-ups such as Simplibuy Technologies, ScienceAdda Learning and KarmYog Education among others, calls for amendment in the angel tax structure.
Many investors and entrepreneurs call angel tax a draconian tax law, especially when compared with laws in Western countries. For example, in the United Kingdom, the Enterprise Investment Scheme was launched in 1994. The purpose was to encourage investments in small and risky companies. It allows investors to claim upfront tax relief on up to 50 per cent of the amount invested and is capped at £100,000 per annum. It also has provisions for the investor to obtain a loss relief in a situation where the chosen investment fails. Further there is no capital gains tax to be paid on profits following the sale of the share in case the investor has held the share for at least three years.
Expectation
Many entrepreneurs are already evaluating shifting to countries which are friendlier and helpful with tax climate, such as the US, Singapore, Germany, etc. It will be interesting to see if the government agrees to consider the demands of the industry during in the 2018 Budget or it simply sticks to its core agenda of tightening the noose of money laundering in the country.
