The government’s Startup India initiative continues to receive flak as the startup ecosystem faces new hurdles, and the ‘angel tax’ controversy affects access to capital. In the last 24 hours atleast two startups have complained their company accounts were frozen by the tax department and money withdrawn on account of angel tax demands. This warrants not just a review of angel tax but a full repeal.

The Tax Backstory

The angel tax dates back to the Finance Bill of 2012 where Section 56(2)(viib) of the Income Tax Act, 1961 was introduced with the purpose of curbing money laundering via inflated share price issuance. It is the tax levied by the government on any private company that raises capital above its fair market value. The difference between this FMV and the price at which the shares are issued is deemed as income (from other sources) and taxed at the maximum marginal rate.

The angel tax controversy has centered around the valuations arrived at during various rounds of startup funding. This has been a problem for entrepreneurial ventures as there is no definitive or objective way to measure a startup’s ‘fair market value’. The determination of this FMV is based on two valuation methodologies: net asset value and discounted cash flow basis. The Department of Revenue has lately started assessing the value of startups based on their net asset value. While the well-intended objective seems to be to crack down on black money, genuine startup funding transactions have come under the scanner of the taxman.

Several startups have found it difficult to justify the higher valuation to tax officials.

And given our revenue administration and operating environment, and the exercise of discretionary powers, rulings, unfortunately, go against the taxpayer. Doing a capital raise, and its pricing, to the satisfaction of the taxman was bound to lead to such consequences, given the blanket approach to taxation, which fails to distinguish between genuine and non-genuine transactions.

Startup India Changes

In January 2016, the government launched the ‘Startup India’ initiative to build a strong ecosystem for nurturing innovation and entrepreneurship. As part of this initiative, the Department of Industrial Policy and Promotion, (now renamed as the Department for Promotion of Industry and Internal Trade), under the Ministry of Commerce and Industry, issued two notifications in 2016 and 2017 covering the eligibility conditions and procedure for recognition as a ‘startup’ and the conditions for availing a tax holiday.

Accordingly, an entity (private limited company or registered as a partnership firm or LLP) will be considered a startup up to seven years since its incorporation or registration; or 10 years in the case of startups in the biotechnology sector. The turnover should be less than Rs 25 crore in any of the previous financial years.

Further, the startup should be working towards the innovation/improvement of existing products, services and processes; and should have the potential to generate employment or create wealth.
A tax holiday was offered for a period of three years in a block of seven years, subject to the fulfillment of the above conditions.

These conditions were also prescribed for availing a tax exemption from the pricing of shares issued by startups. Approval of a broad-based ‘inter-ministerial board’ was mandated, accompanied by the requirement of a valuation report from a merchant banker, which proved to be burdensome.

When several startups were reportedly slapped with tax demands on the angel funding they raised, and in some cases, penalty proceedings were initiated for alleged tax defaults, instructions were issued within the Revenue Department directing tax officers to refrain from taking coercive steps to recover the outstanding tax demands.

After persistent requests from stakeholders for the repeal of the angel tax, the erstwhile-DIPP, in January 2019, notified various amendments that allowed startups, which are recognised under the Startup India initiative, to seek exemption from the Central Board of Direct Taxes.

The requirement of a merchant banker’s valuation report has been done away with.

The approval of the inter-ministerial board for angel tax exemption is no longer required.

The timeline for a CBDT decision an application routed via DPIIT has been rationalised to 45 days.

There is no change in the threshold limit of receiving funds (Rs 10 crore) or any tweak on the net worth requirement/condition on the investor.

However, startups are not pleased with the clarification and have sought a blanket exemption from the angel tax, fearing exercise of discretionary powers by the taxman. While the process has been simplified, the changes will not, on the face of it, benefit all startups. Those planning to raise funds from personal connections or smaller investors will continue to face hurdle like dismissals over principles of valuation from the tax department.

Several angel investors may also not be comfortable disclosing confidential information about their financials while investing in startups.

An Uneven Field

One major concern, which remains, is that the provisions apply only to investments made by resident investors, putting them at a disadvantage relative to non-resident investors.

What was introduced in 2012 as an anti-abuse provision to curb black money and check money laundering has ended up as a tax burden on capital raised at a premium by an unlisted company.

Only a small fraction of startups are registered with the government, and the rest remain vulnerable to such tax claims. The tax department invariably challenges valuations furnished by taxpayers, if the explanation offered is not satisfactory.

The only way to put this entire controversy to rest, once and for all, is to repeal the angel tax with retrospective effect.

The taxman continues to have Section 68 (pertaining to unexplained cash credits) of the Income Tax Act to act in situations of under-pricing of shares.

There also have been suggestions to create a register of ‘accredited investors’, which would not be subject to the angel tax. The accreditation approach has been used by many countries, however, not for the purpose of addressing this particular issue and this may practically seem onerous under Indian conditions.

This Isn’t A Sop

The cry for relief from the angel tax is not about a tax holiday being disallowed, but about addressing the difficulty new ventures face in securing appropriate funding. If the government, in its wisdom, wishes to continue with the law, it can consider streamlining the provisions like a higher threshold limit, and leeway where share capital is less than Rs 25 crore.

While the government appears to have appreciated the problem and made a timely intervention in the form of administrative clarifications, they haven’t proved to be enough.

The Finance Minister could have intervened in the Interim Budget announcement on Feb. 1 and assuaged the sentiments of startups. However, earlier this week, in a meeting convened by DPIIT with a select group of startups and angel investors and CBDT officials, it was revealed that a working committee shall be formed to review the angel tax issue with a workable solution in a matter of days, though an official update is awaited.

When attempts are made to give innovation and entrepreneurial ventures a policy boost, the counteraction of onerous procedures, bureaucratic delays, and officials exercising discretionary powers has had a crippling effect on the startup ecosystem.

When startups raise funds, there is an onus on promoters for delivering a stellar performance. Why would a smart investor, unrelated to the promoter of a startup, fund the venture without evaluating its potential? Hence, the case for doing away the angel tax for startups is worth exploring. Legislative and administrative measures must aim to foster entrepreneurship and promote innovation, by creating an ecosystem that is conducive to growth and building value.

Mukesh Butani is Founder of BMR Legal. Views expressed are personal.