Black money in startups? Angel tax is in fact obstructing entrepreneurship, say experts

Investors and entrepreneurs are disappointed over a recent government move to impose an income tax rule on angel investment in a bid to crack down on suspected black money flow into the country's startup ecosystem.

A tweet from startup entrepreneur Mohandas Pai, a former Infosys, a former director of Infosys, set the proverbial pigeon aflutter among the startup ecosystem.

It is not that the tax is a new development. In fact, angel investors have been making representations to the government about it but when someone like Pai tweets, it does get noticed

The startup ecosystem in India is in its nascent stage though a few have become Unicorns. But after the boom period of around two years ago, reality has struck and funding is not coming easy for the startups. Earlier, an idea would get funds but the flow stopped when many of them crash landed after being infused with funds as the product or service was not accepted by the market in some cases while some floundered as cash-burn was at a higher rate with no healthy bottomlines.

A startup is basically an idea which has some ability to be marketed. The startup founder/s then raise money from themselves and friends to get the idea ground up. After that, it usually goes to angel investors who help them to develop the idea, may say if it needs to be tweaked or not, give them inputs on what markets to target, etc. Angels put in money into the project and also handhold the startup. After it gets traction and needs more funds, is when the Venture Capitalist steps in.

Despite several promising and encouraging programmes by the government to boost the startup sector in India, Budget 2012 introduced Section 56 in the Income Tax Act which gives the authorities the power to levy tax on any consideration more than the fair value against issue of shares.

Section 56 (2) (vii) (b) of the I-T Act states:

“Any consideration received by a company (startup) from a resident, against issue of shares, exceeds the fair market value of such shares, such excess consideration is taxable in the hands of the startup, as an income.”

Any such extra inflow is taxable as “income from other sources” under Section 56(2) of the Income-Tax Act and charged the corporate tax rate, resulting in an effective tax of over 30 percent.

 Black money in startups? Angel tax is in fact obstructing entrepreneurship, say experts

Representational image. Reuters.

However, in July 2016 the government scrapped angel tax only for ‘eligible’ startups (read here). According to the notification, only startups which fulfil the conditions specified by the department of industrial policy and promotion (DIPP) as per a circular dated 17 February 2016 are eligible for the angel tax exemption. ‘Eligible’ start-ups can get the tax benefit provided they obtain a certificate from the inter-ministerial board of certification. Predictably, only a few would fit the above description.

Though the tax was introduced in 2012, it is only now that the Central Board of Direct Taxes (CBDT) is questioning investors, a Times of India report said.

Angels miffed

Angel investors expressed their disappointment at what they consider to be a ‘slap’ on the face of the startup ecosystem which the government is trying to promote through many programmes.

Paula Mariwala, Partner, Seedfund and Co-Founder, Stanford Angels termed the government’s actions ‘completely bizarre’. She said that the government had no business questioning valuation of a startup which basically has no revenues. “As an angel investor, I may value a startup at x amount depending on the market reach of its product/services. Valuation cannot be linked to revenues and should be linked to projected value,” she says.

Citing an instance, Mariwala says that if a company is building a product and test-markets it and need angel funding, the questions such an investor asks is about market access. A value is projected based on the sale of the product to one customer.

"There is no profitability matrix. There is no math that can say how the startup arrived at this valuation. How is a chartered accountant going to value that?” Mariwala asks.

If a startup founder can pay tax, why does he need to raise money from angels anyways, ask another investor. If angel money is going towards payment of taxes, why would any angel investor come forth to fund a startup.

The number of angel and seed funding deals halved to 435 in 2017 from 901 in 2016, according to report in VC Circle. The total disclosed valued of these deals also fell sharply to $245 million from $374 million.

The angel investor community has been making representation to abolish the tax. They suggest the government should bring in a regulator, be it CBDT or Sebi, and then give those registered with them exemptions.

“We understand the government’s rationale is to weed out black money but it cannot use the same brush to paint everyone who is investing in start-ups from among angel investors,” says Nandini Mansinghka, chairperson, Mumbai Angels. She suggests the government should identify angel networks and give them accreditation like in the US. The government must arrive at a consensus on those individuals who put in big stakes into a venture.

There are cases of persons in power favouring a sector or startup and in return being given large number of shares for money they invest, said an entrepreneur on conditions of anonymity. Angels anyway don’t invest huge sums. “Who will decide on fair value? What is the definition,” the entrepreneur asked. If the move is to ferret out black money, the government must then look at what it has collected by way of angel tax, the entrepreneur said. “Is the government saying before Section 56 of the I-T Act, no black money was being generate in the country?”

Startups find it difficult to get funds and with investors not willing to part with their funds easily to this sector, the income tax department is only constricting the sector, some experts said. "If the investor is going to be subjected to the scrutiny by the income tax department it makes matters furthermore cumbersome,” said Ishan Singh of Mumbai Angels.

He said that since start-ups have emerged as the growth drivers of the economy, and have been praised for bringing in innovation and creating more job opportunities, the government needs to resolve the matter of angel tax. “Authorities need to regulate and streamline the space while making tax structures more conducive from an investment standpoint. The same will further encourage private investments, giving a massive boost to the pivotal sector."

The government needs to do something to do away with the angel tax so that the startup ecosystem can grow.

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Updated Date: Dec 22, 2017 11:47:08 IST