Angel Tax: Will The Wicked Consume The Righteous?

Section 56(2)(viib), also called the ‘Angel Tax’, is a tax levied by the government on any private company that raises capital above its fair-market value.

(Photo Courtesy: BloombergQuint)

How startups are ending up as collateral damage in a war against black money.

In India’s quest to become a $10-trillion economy by 2030, startups play a pivotal role in job creation, value accretion, and innovation. India is the third-largest startup ecosystem in the world with more than 50,000 ventures launched in India creating $130 billion of value and raising $38.5 billion between January 2014 and September 2018.

Yet the tragedy of our system is that out of 26 unicorns in India and of the 30 soonicorns (potential unicorns), a third of them have their headquarters outside India; and out of all the investments into these companies, only 10 percent comes from domestic capital.

India runs the risk of becoming a digital colony where the value generation lies within the country but the shareholder and value accretion is benefiting foreign nationals.

While the present government has done remarkable work in creating an entrepreneurial milieu in the country via the Startup India scheme, Atal Innovation Mission and other structures, there still exists a lightning rod of discontent and harassment for startups: Section 56(2)(viib) of the Indian Income Tax Act, 1961.

Valuing Without Investing

Section 56(2)(viib), also called the ‘Angel Tax’, is a 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 are taxed in their hands at the maximum marginal rate.

The concept of taxing capital receipts and investments as income is unique in the principle of taxation and exists only in India in this clause. Though the law offers the choice of valuation to the assessee company, what we’re witnessing is the assessing officers disregarding this freedom and instead taking it upon themselves to value the company, like an investor would – without putting the requisite capital behind this themselves.

These officers ignore the valuation report prepared by a merchant banker or a chartered accountant in favour of the current net worth of the company. Not even listed companies trade at their book values since this value is a historic one, whereas the valuation of the company is supposed to take into consideration future growth and earning potential as well.

Furthermore, to establish the creditworthiness of the investor (Section 68), the assessing officers are demanding the bank statements, income tax returns and financial statements of all the investors from these companies.

Given the sensitive nature of these documents, not every investor feels comfortable sharing them with their investee company.

In spite of the tax department having these documents on record, which can be accessed by them via the investor’s Permanent Account Number, these heavy demands are made of the companies with a very narrow compliance time frame. If this continues to be the state of affairs, the angel funding ecosystem, which has seen a decline of 48.5 percent, from 653 investors in 2016 to 343 in 2018, will ultimately dry up.

Domestic Discrimination

Angel funding is the highest risk strata of funding since these companies are just starting off or just developing their product or go-to-market strategy.

While the UK, Singapore, the US and others have schemes and tax breaks to incentivise angel investors, India is taking a regressive step to dissuade angels from investing in these companies. Ironically, these measures of sections 56(2)(viib) and 68 only apply to domestic investors and not to non-resident investors.

This discrimination against domestic investors is one of the reasons why domestic capital forms such a small part of the capital pool investing in startups in India.

This aggravation faced by startups and investors runs directly counter to the promises made by the government of encouraging entrepreneurship and increasing the ease of doing business. The removal or change of this draconian measure has been a constant demand of the startup ecosystem since the government took over, yet no measures have been taken.

Though this angel tax section was not a product of the current government, they are facing the blame for the consequences of this and the effect it has on entrepreneur morale.

The current setup of receiving Inter-Ministerial Board approval, the only succour from these sections, only applies to those companies incorporated after April 1, 2016, whereas the majority of these companies and cases are related to prior years. Drastic change is essential for these startups to thrive.

Some entrepreneurs, who are facing this the second time around, are so fed up that they want to shut down the company, relocate to a more favourable jurisdiction and then open a subsidiary in India, thus shifting the value creation cycle outside India.

Punishing The Innocent

The 2012 budget speech prefaced the introduction of these measures by stating that they were to curb the laundering of black money through private limited companies.

But it begs the question as to why startups, who raise money through bank transfers and not cash, file all the forms with the Registrar of Companies and the Reserve Bank of India for their capital raises, obtain a genuine valuation report and follow the law to the letter and spirit are being harangued in this fashion.

Laundering money through normal banking channels, with a visible paper trail that anyone can access via the Ministry of Corporate Affairs records, runs counter-intuitive to the clandestine and trail-less nature of laundering money.

In the words of the noted jurist, William Blackstone, “It is better that ten guilty persons escape than that one innocent suffer”.

Yet the current system seems fine to invert that statement and allow ten innocents to suffer in order to catch a single guilty culprit.

If the aim is to curb the laundering of funds via private companies, then better filters are required. Only companies who have not filed the forms, received money in cash, or cannot provide the PAN of their investors should be targeted.

The tax department should leverage big-data analytics to verify if the investors in startups have the financial ability and tax-paid money to make such investments. Passing the onus on to a company to provide this information and to do the tax department’s job is ludicrous.

Armchair Valuations

Valuation is both an art and a science. Every book about valuation speaks about how different valuers can arrive at different values using different techniques.

It is not the job of the tax department to dictate how a tax-paying citizen should invest his money or what value he sees in a startup.

Valuing a company without making the investment is taking armchair investing to a different level.

With the upcoming election and the discontent around this measure reaching a fevered pitch, it is imperative that Prime Minister Narendra Modi himself intervenes and sees that law-abiding companies are not eviscerated by such arbitrary action.

After all, a tax is not the best form of defence.

TV Mohandas Pai is Chairman at Aarin Capital; Siddarth Pai is Founding Partner at 3one4 Capital.

This piece was originally published on BloombergQuint and has been republished with permission. The views expressed are the authors’ alone. The Quint neither endorses them nor is responsible for them.