Angel Tax: Implication on Startup Ecosystem By CS Karan Sahi


Introduction
 
Angel tax means the tax payable by unlisted companies during the raising of capital wherein the share price exceeds the fair market price of the share sold. The tax was initially conceptualized in the 2012 Union Budget by then finance minister Pranab Mukherjee with an endeavor to curtail the flow of illegitimate laundering of funds. The provision had a draconian impact on angel investments in startups ecosystem and sending shivers down the entire ecosystem. The notice from the Income Tax Department has been served to 73% startups that raised angel funding since their inception (before or after 2011) as per the survey conducted by PE, VC body Indian Private Equity and Venture Capital Association (IVCA) and community social media platform LocalCircles.
 
Provision

The relevant extract of applicable provisions are reproduced below:-

Section 56(viib) provides that where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:

Provided that this clause shall not apply where the consideration for issue of shares is received—

  1. by a venture capital undertaking from a venture capital company or a venture capital fund; or
  2. by a company from a class or classes of persons as may be notified by the Central Government in this behalf.
Section 68 provides that where any sum is found credited in the books of an assessee maintained for any previous year, and the assessee offers no explanation about the nature and source thereof or the explanation offered by him is not, in the opinion of the Assessing Officer, satisfactory, the sum so credited may be charged to income-tax as the income of the assessee of that previous year:

[Provided that where the assessee is a company (not being a company in which the public are substantially interested), and the sum so credited consists of share application money, share capital, share premium or any such amount by whatever name called, any explanation offered by such assessee-company shall be deemed to be not satisfactory, unless—
 
  1. the person, being a resident in whose name such credit is recorded in the books of such company also offers an explanation about the nature and source of such sum so credited; and
  2. such an explanation in the opinion of the Assessing Officer aforesaid has been found to be satisfactory:
Issue
 
The issue pertaining to the Angel Taxation got escalated and snowballed into a major controversy when Travel Khana and Baby Go Go saw large sums of money being taken out of their bank accounts by the tax authorities. The management of Travel Khana was baffled when the bank account was depleted by Rs 33 lakh on account of tax remittance and to further compound the problem Travel Khana’s account with SBI was frozen. Similarly, Startup Baby Go Go witnessed Rs 72 lakh had been deducted from the company account by the CBDT. Adding salt to the wounds, CBDT issued a press release dated 08.02.2019 claiming that all procedures were diligently followed by the Assessing Officer and the start-ups are to blame for non-compliance.

The issue arises due to unreasonable expectation by the tax authorities from the startup founder. The authorities expect the startup management to share investor’s bank statement, financial statements, and income tax returns. However, the information sought to be confidential in nature are not meant to be shared with a startup founder during the period of investment.

Panacea
 
Ever since the inception of ‘Start-up India’ in 2016, there has not even a single notification from the government that garnered so much appreciation from Indian entrepreneurs. The recent notification from DPIIT dated 19th February 2019 signaled the death knell for the dreaded ‘Angel Tax’. But as always, the devil lies in the details.

Before dwelling into the specifics, let us understand the benefits reaped from the current notification:

  1. The period for recognition as a startup stands to increase from 7 to 10 years.
  2. The turnover limit has been increased from the existing Rs 25 crore to Rs 100 crore;
  3. The condition for claiming exemption from Section 56 (2) (viib) has been relaxed;
  4. The limit mentioned above to exclude the investments received from:
              • A non-resident
              • A Venture Capital Fund or a Venture Capital Company
             • Specified company (listed companies whose shares are frequently traded and who have a net-worth exceeding Rs 100 crore or turnover exceeds Rs 250 crore)

  1. The Prior approval from Inter-Ministerial Board (as per the April 11, 2018 notification), and then from the CBDT in a time-bound 45 days (as per the relaxed notification on January 16, 2019), has now been replaced with a simple declaration in Form 2.
  2. The Long Form 2 required for substantiating the higher valuation with supporting documents and explanations have also been dispensed.
  3. Now, eligible startups are not required to obtain merchant banker valuation report.
  4. All the benefits shall continue to be available after receiving the recognition as a ‘Startup’ through online application over the mobile app or portal set up by the DPIIT.
Demon in the Details
 
While the majority have hailed the move and government’s intent in giving startups a nearly free hand to grow, an undertone of dissent still echoes the ecosystem:

  1. There is ambiguity regarding income notices received prior to the notification. Moreover, the notification doesn’t address assessments made under Section 68.
  1. Even though an increase in turnover to be music to ears for the founders but the startups with a high growth curve, or ones addressing a larger market size, may not be able to leverage it favorably.
  1. There is voice echoing from the industry that profitability as a criterion for tax exemption instead of turnover or time since incorporation shall serve as a better representation for the purpose of recognition as a startup.
  1. Investments received from AIF Category II and other sub-categories of Category I AIF are still outside the purview of the exemption.
  1. Another Dampen is the restriction laid done by DPIIT on the end use of the money for the funding. The undertaking needs to provide by the startups that it shall not to invest in immovable property, transport vehicles above Rs 10 lakh, loans and advances, capital contribution to other entities, and some other specified assets such as shares and securities and jewelry, except in the ordinary course of its business. Further, startups cannot invest in shares and securities. It is common practice to park the surplus money received in debt mutual funds, however, the continuation of such practice to make the startups ineligible for the exemption.
  1. Companies are restricted from making capital contributions to any entity, which means that a startup cannot have subsidiaries, which makes it difficult for startups with overseas arms or operating in regulated spaces such as fin-tech and e-commerce. The group of companies is not just desirable but necessary to comply with regulatory requirements. It shall compel startups to alter their capital structure to seek any benefit under startup scheme.
Ruining the golden opportunity
 
There has been a substantial reduction in the amount of funding for angel investment from the year 2016. According to Inc42 DataLabs, in 2016, the number of early-stage investment deals stood at 624. It is in a downward spiral since active income tax notices to the startups. In the year 2017, the number decreased by 11.69% to 551, and in 2018, it fell by a whopping 46.95% to 331 as compared to the base year 2016.

A similar trend was observed in the number of deals carried out by major early-stage investment firms (angel investors and networks), which declined significantly in 2018 from 2017. The number of deals fell from 711 (2017) to 478 (2018) in the case of angel investors and from 75 (2017) to 62 (2018) in the case of angel networks.

On the contrary, the top ten listed companies in India are sitting on cash and cash equivalents of over 2.7 lakh crore, which is around $38 billion. However merely $38.5 billion is raised by all Indian start-ups from 2014 to 2018, of which not even 10% comes from Indian sources. Companies like TCS, Infosys, Indian Oil, are buying back crores of stock an indication that the company believes that the money is better returned to investors as opposed to being invested by the company.
 
Conclusion

When entrepreneurs have to go through a tough process for raising capital, any taxes on the capital raise is likely to kill the startup ecosystem. India cannot achieve the vision of creating a digital colony unless we have more active participation from domestic pools of capital. Our listed companies are sitting on piles of cash and, yet, their acquisitions of and investments into Indian start-ups are paltry. The need of the hour is clarity on the issue shall provide the necessary impetus to the early angel investment atmosphere and bring in the necessary liquidity in the system.
 

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