Startup India vs angel tax: Union Budget 2019-20 has offered some sops to startups, but will bureaucracy play spoilsport?

It’s a Battle Royale out there. We have one of Prime Minister Narendra Modi’s most brilliant projects, Startup India, which promises to increase both employment as well as self-employment in the country. Just look at the over 30,000 employees of Flipkart, or the over 5, 50,000 drivers used by Ola Cabs, and you begin to see the impact of startups on employment. However, pitted against Startup India is a formidable opponent, popularly known as Angel Tax.

But let’s start at the very beginning. In the year 2012, the Finance Ministry introduced an interesting piece of legislation to curb money laundering. As you are aware, startups need to raise money at an early stage, typically from angel investors. Now the key is the valuation at which this money is raised. Suppose a startup issues 10,000 shares to angel investors, and values each share at Rs 1,000. In other words, the company has raised 1 crore.

Now this is where things get murky. What if the ITO (Individuum Team Organisation) says that the fair value at which each share should have been issued was not Rs 1,000 but just Rs. 200— in other words the value at which each share was issued was highly inflated? And what if it then says, that the reason for inflating the value is that the balance Rs 800 per share was returned by the company to the investor as cash? An ingenious scheme for money laundering—or converting black money to white. And so the difference between the valuation at which the funds were raised, and the fair valuation as perceived by the ITO, is treated as “income” of the startup—in this case 10,000 shares times Rs 800 or 80 lakhs.

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What next? The startup is asked to cough up 30 percent tax on this 80 lakhs. Cutely called Angel Tax. Period.

Representational image Thinkstock.

In fact the tax authorities take it a step further. Were the investors themselves genuine, or simply fake entities? And therefore they start to chase the investors as well, thereby putting them off and ensuring that they don’t invest in startups again. And what did the government say? Register your startup with the Department of Industrial Policy & Promotion (DIPP), get a certificate from a Chartered Account for your valuation, and you will be exempt from this tax.

While that is okay in principle, it has not been happening on the ground. As of right now, there are several startups where the founders are wasting time on battling tax notices rather than focusing on their business.

Let’s examine the question of valuation in a little more detail. One of the most common methods of valuing a company is to use DCF or the Discounted Cash Flow method. In simple terms, we look at the future earnings projections of the company, and convert that into a current valuation. Great. Except that projecting future earnings needs some past earnings, which becomes the basis. Perfect for listed companies which have been around for years.

But what about a startup that began operations perhaps six months ago? It may have no earnings yet, so how do you project non-existent earnings into the future? No matter what method you use, the valuation of a startup remains very highly subjective. So, who is to figure out what the fair valuation should be? And till this is done, do the startups happily keep paying angel tax?

By the way it gets worse. As part of their fund-raising process, startups do make future projections. But these are rarely met. Remember, these are startups and are usually venturing into a completely new space with projections being guesses at best. And what do the tax authorities say? “Gotcha! You had inflated valuations in the first place”. So the noose only gets tighter. Don’t get me wrong. I am all for catching money-launderers. The country has had enough of such 'luminaries' like Nirav Modi and Mehul Choksi. But why do we assume that a startup founder is a money-launderer, till he goes through a complex process and proves himself to be innocent?

Fortunately, the government has been listening. A clarification issued in February this year had liberalised the conditions that a startup must satisfy in order to claim exemption from this tax—for instance by increasing the funding raised from an earlier 10 crores to 25 crores—albeit with riders. The government had also said that angels who invest through certain funds (technically called AIFs, or Alternative Investment Funds), would not be subject to angel tax, since the AIF was a government-approved fund anyway. In the Union Budget 2019-20, they extended this to more such funds, namely AIF-I and AIF-II.

The Budget also said that startups which had approvals from the government would not be subject to angel tax. And that any income tax officer would need the authority of his boss to chase currently open cases. Will all this work? Will our famed bureaucracy let it work? We certainly hope so. And we hope there will be achhe din for start-ups after all!!!

(The writer is a professor at the Management Development Institute, Gurgaon, and a Director with Lead Angels)