7 PM | Timely review: On start-up tax | 6 February, 2019

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Context:

The government has set up a five-member working committee to look into the angel tax issue and come up with guidelines.

What is Angel tax:

• Angel tax is a term used to refer to the income tax payable on capital raised by unlisted companies via issue of shares where the share price is seen in excess of the fair market value of the shares sold. The excess realization is treated as income and taxed accordingly.
• The tax was introduced in the 2012 Union Budget to arrest laundering of funds by Shell companies. It has come to be called angel tax since it largely impacts angel investments in startups.

Who are Angel investors:

• Angel investors are a class of well-to-do investors, usually experienced industry folk who take equity stakes in startups.
• They take very early-stage businesses under their wing. Typically, institutional investors such as venture capital funds or private equity funds do not like to commit capital to tiny businesses.
• Funds contributed by Angel Investors are known as Angel Funds. Angel Funds in India, are regulated by SEBI.

What is the issue:

• The angel tax is a 30.9 % tax levied on investments made by external investors in startups or companies. The entire investment is not taxed, only the amount that is considered above “fair value” valuations of the startup, classified as ‘income from other sources’ in the Income Tax Act of India.
• The problem arises because startups are often valued subjectively on the basis of discounted cash flows, without taking into account intangibles like goodwill.
• This can cause differing interpretations of “fair value” and leave startups vulnerable to unduly high taxes because the taxman feels the investment is too high over their valuation.
• At least 80 startups have received notices to pay angel tax since last year.
• Angels investors have also received multiple notices asking them to furnish details on their source of income, their bank account statements and other financial data.
• Income-tax officers claim that the scrutiny on start-ups is mainly due to concerns over money laundering

Why Industry raised the issue of Valuation of Startups:

• The valuation of a startup is usually based on a commercial negotiation between the company and the investor, and is a function of the company’s projected earnings at that point in time.
• However, since startups operate in a highly uncertain environment, many companies are not always able to perform as per their financial projection. Equally, some companies exceed the projection by a long mile if they are doing well.

Impact of Angel Tax on Startups:

• Since many unlisted and early-stage startups rely heavily on funding the taxation will limits investors from putting their money and trust on fledgling and early-stage startups, which in effect stifles more people to come forward and start their own.

Steps Taken by Government to protect startups:

• Start-up India Initiative: Tax exemptions on income tax for three years and Tax exemption on capital gains and on investments above fair market value (angel tax)
• Tax exemptions: Tax exemption to startups under Section 56 of the Income Tax Act in cases where the total investment including funding from angel investors did not exceed Rs 10 crore. This limit has been increased to 25 Crores recently.
• Changed Definition: The government has amended the definition of a startup, entity shall now be considered a startup up to seven years, at present, the period of consideration is five years, thereby making it easy to avail of incentives and promote entrepreneurship under the Startup India scheme.

Way Forward

• Ensuring fair assessment: Income Tax department should lay down detailed parameters for fair assessments, before making such additions to income, and to check the genuineness of the transaction. Otherwise it will not only discourage entrepreneurs but will also add on to an already long queue of tax litigation
• Simple Registration of Angel Investors: The existing registration as an Alternate Investment Fund (AIF) or a Venture Capital (VC) firm is a very long and expensive process. The right way perhaps should be to ask angel investors to register in the Income tax portal with Tax residency certificate or PAN Card number and other details.
• Simpler and more process driven Start-up India registration: The discretionary powers of DIPP for granting Start-up India registration for income tax benefits should be more automated and process driven rather than giving discretionary powers to the officers to determine if the start-up is innovative or not or whether it would generate enough employment or not.

Source: https://www.thehindu.com/opinion/editorial/timely-review/article26187160.ece