What is worrying is that this year, angel investments and seed funding deals have fallen by 40 per cent, ringing alarm bells in the start-up community in India.
After some startups in Bengaluru and Mumbai got notices from the income tax department, the issue of angel tax is at the centre of much debate. Dev Chatterjee unravels the issues involved
What is angel tax?
Angel tax relates to Section 56 (2) (vii b), inserted in the Income Tax Act vide Finance Act of 2013.
It is a levy of 30.9 per cent on the amount exceeding the fair market value of shares issued by unlisted companies (mainly start-ups) which will be treated as income from other sources.
This fair value is determined by the tax authorities after the investments are made by the angel investors and are taxed accordingly.
Many start-ups have complained that they have received tax notices to pay tax as high as Rs 4 million after they received Rs 10 million as investment from angel investors a few years ago.
The company's valuation is based largely on how angel investors assess the start-ups to fare in future rather than documented income or assessing the current assets of a start-up.
The tax, they allege, goes against the Prime Minister Narendra Modi's 2014 election manifesto promise to put an end to tax terrorism and make it easy to do business in India.
Why was the amendment necessary?
The idea behind amending the Income Tax Act was to tax those closely held private companies that have been used as a tool for money laundering.
While money laundering might have happened in some cases, it has also singed the start-ups badly.
Tax authorities say many unlisted companies brought in undisclosed money of promoters by issuing shares at high premium from the overseas route, which is normally over and above the book value of the shares of the company.
Why are the start-ups crying foul now?
Many start-ups have started receiving tax notices in the past few weeks and that has triggered the current furore.
The tax notices have landed despite assurances from the Indian government that start-ups will not face any action.
While the India-based companies are getting hefty tax notices, start-ups with a base in Singapore and other tax havens have escaped the tax notices.
They allege that companies started by young entrepreneurs are in the firing line of the income tax department as they don't have the resources to fight long and expensive legal battles with the bureaucrats.
What is worrying is that this year, angel investments and seed funding deals have fallen by 40 per cent, ringing alarm bells in the start-up community in India.
While a large part of the decline can be attributed to the end of the euphoria period of 2015 and 2016 when start-ups were able to raise money relatively easily, the enforcement of angel tax must bear part of the blame, say experts.
Will the angel tax impact investments?
Yes, it would, say tax advisors.
The start-up eco-system in India is nascent and fragile.
Such notices spook foreign investors and keep them from making long-term investments in India.
Most of the unicorns have already transferred their tax residency overseas in order to escape the tax net in India.
Take for example, the entire $16 billion Flipkart-Wal-Mart transaction.
It was done overseas as none of the investors were based in India.
With this, many early investors of Flipkart did not pay tax in India.
How should start-ups that have received the tax notice deal with the situation?
While the government has assured start-ups that it will not tax investors with a retrospective provision, tax lawyers say income tax authorities will have to be convinced that the start-up did not indulge in any money laundering activity and that the money received was used for genuine business purposes.
Under Section 56 of the law, the IT officer has to be satisfied with the valuation but they do not always have the investment background to understand the valuation.
Anish Thacker, tax partner, EY India, said, "The remedy is to challenge the notice on the ground of applicability of section 56(2)(viib).
"If one goes to the memorandum explaining the provisions of the Finance Act, 2012, where the provisions of section 56(2)(viib) were introduced, one will see it was a section introduced to curb the alleged laundering of black money by getting high premiums from shareholders of questionable means.
"In parallel, there must be a dialogue with the government to reduce the impact of this section 56(2)(viib) as enacted.
"Either the section's applicability be restricted with retrospective effect in the Budget on February 1 (preferred) or a suitable communication be addressed by the CBDT to the field officers, to withdraw the notices issued to genuine investors."
What is the Indian government saying now?
In a statement on December 19, the Department of Industrial Policy and Promotion said it has taken notice of the news reports regarding the issue of notices by income tax authorities to angel investors ansd start-ups.
The DIPP, in consultation with the Department of Revenue, has put in place a mechanism since April 2018 to grant exemption from the provisions of Section 56 (2) (viib) of the Income Tax Act to genuine investors in recognised start-ups.
'The DIPP has again taken up this matter of issue of IT notices with the DoR so that there is no harassment of angel investors or start-ups.
'The government is committed to protecting bona fide investments into start-ups,' the statement said.
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