Start-ups shouldn't lose sleep over Angel tax; only wolves in sheep’s clothing need to panic
It is again not only the angel investors who are exempt from tax if the startup makes the grade but also the startup itself
Angel tax which is being demonised today by many as though it is a NDA baby, in fact and significantly is a UPA 2 brainchild with its origins in the Finance Act, 2012 piloted by the then Finance Minister Pranab Mukherjee.
It is admittedly rooted in sound logic---no crook should be allowed to launder his black money by bringing in capital at exaggerated valuations. Section 56 (2) (viib) which treats the difference over the actual capital received by a closely-held company from a resident Angel investor and its fair market value as its taxable income is an attempt at reining in money laundering. In other words such a privately-held company that acts as the handmaiden of the crooked promoter will have to pay a 30 percent plus tax on the exaggerated credit as income from other sources.
Of late, tax demands have gone out to start-ups asking for as much as 50 percent tax plus penalty. Critics are dubbing the tax administration’s act as tax tyranny that also runs counter to the government’s avowed objective of giving a leg-up to startups through Start Up India and Make in India initiatives. But then if a good scheme is abused, the law should come down on the misuse like a tonne of bricks. Shouldn’t it?
The critics aver that there is no abuse but such exaggerated valuations are inherent in the very nature of start-ups---they are all about innovative ideas or cutting edge technology which always carries substantial premium. This argument doesn’t wash as it is an inversion of what happens in the venture capital investment---a venture capitalist takes the risk of investing in an unknown quantity with the expectation of exiting at a substantial premium when the investments start bearing fruits with the new and untested product or technology finding acceptance in the market.
What applies to a venture capitalist equally applies to an Angel investor. A premium is collected from the latecomers who step into the scene after risk-taking is over. Incidentally, the above scheme of taxation enshrined in section 56 (2) (viib) is not applicable to venture capital-financed companies. This is the crux of the issue. Money laundering was suspected only in Angel investments.
In 2016, the Central Board of Direct Taxes (CBDT) did exempt startups conforming to the definition and certification of Department of Industrial Policies and Promotion (DIPP) from Angel tax. But that precisely became the sour point with the start-up industry---DIPP conditions were difficult to adhere to.
To be recognized as startup, as per DIPP, it must not be older than seven years and must have an annual turnover that does not exceed Rs 25 crore.
In 2018 vide DIPP notification G.S.R.364 (E) dated 11 April, 2018 the air was further cleared through an elaborate regime for making the grade for tax exemptions which reads as follows:
An entity shall be considered as a Startup:
i. if it is incorporated as a:
a) Private limited company (as defined under Companies Act, 2013);
b) Registered as a partnership firm (registered under section 59 of the Partnership Act, 1932);
c) Incorporated as Limited Liability Partnership (under the Limited Liability Partnership Act, 2008);
ii. Seven years has not elapsed since the date of its incorporation or registration (in case of biotechnology sector, the period shall be up to 10 years from the date of incorporation/ registration);
iii. Turnover of the entity for any financial year since incorporation/ registration has not exceeded INR 25 crores;
iv. Entity is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.
Provided that an entity formed by splitting up or reconstruction of an existing business shall not be considered a ‘Startup’.
It is not enough for the start-up to meet the DIPP norms. In addition, the Angel investor must also be the one with a minimum net worth of Rs 2 crore, or an average returned income of over Rs 25 lakh in the preceding three financial years. This is a sound move to stop new moneybags in their tracks, preventing them from pretending as good souls while their sole objective is money laundering.
It is again not only the Angel investors who are exempt from tax if the start-up makes the grade but also the start-up itself. A Private Limited Company or Limited Liability Partnership incorporated on or after 1 April 2016 but before 1 April 2021 can apply to the Board in FORM 1 to avail certificate for claiming 100 percent tax exemption under Section 80- IAC of the Act on profits for any three consecutive years out of the initial 7 years of the start-up. A certificate from inter-ministerial board (IMB) has become a prerequisite for claiming the twin exemptions.
The further hardening of stance by the Narendra Modi government is understandable. Exemptions invite charlatans in droves. The truth is share capital is not sacrosanct and hence impervious to manipulation. Companies’ capital is often used as a laundering machine.
More than two decades ago, the Delhi High Court was shocked to find the promoter of Sophia Investments Ltd indulging in money laundering by getting made some 35,000 demand drafts as application money for allotment in the IPO made by the company.
Congress President Rahul Gandhi’s beef against Rafael deal has also got something to do with alleged capital manipulation. He says Anil Ambani’s company was chosen as one of the offset partners and received Rs 30,000 crore as bribe for Prime Minister Modi disguised as capital from Dassault—the French fighter plane manufacturer, though admittedly he has so far not produced any evidence. Net-net, the regime for start-ups is still not a nightmare except for few wolves in sheep’s clothing.
(The author is a senior columnist and tweets @smurlidharan)
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