Here is all you need to know about Angel tax controversy and its impact on startups.
Start-ups are evolving to become the blood of economies. In 2018, India ranked 3rd for Tech Innovation Leader globally, following U.S and China.
2018 ended with the worries about so-called ‘Angel Tax’ or section 56 of the Income Tax Act.
What is Angel Tax?
The tax is evolved to be known as ‘Angel Tax’ because it is primarily imposed on startups when raising funds from angel investors. It was introduced in 2012 by the then Finance minister Pranab Mukherjee, under section 56 of the I-T Act.
The aim of Angel Tax is to stop money-laundering which was routed by funding bogus start-ups. In mid-2016, this so-called ‘Angel Tax’ norms were relaxed to boost entrepreneurship and start-up culture in India. Till today Angel tax notices are given by the tax authorities when they have concerns regarding the valuation of the company.
When is Angel Tax levied?
Angel Tax is levied on startups under the head ‘Income From Other Sources’ (IFOS) under section 56(2)(viib), when:
- Funds raised via share capital
- Investment is more than INR 25 crore (After 19th Feb 2019. This limit earlier was INR 10 crore)– including share capital and premium
- Valuation is seen to be higher than its ‘Fair Value’ or FMV i.e. ‘Fair Market Value’
The domestic investor in preceding financial year has:
- The income of less than INR 50 lakh(increased from INR 25 lakh)
- Net worth or capital invested- less than 2 crore,
The tax rate is 30.9% on the value more than the FMV ‘Fair Market Value’, at time of investment.
Although it was targeted at domestic investors, however, the funding received from non-Indian investors also covered under the head ‘Unexplained Cash Credit’.
Valuation experts also got show-cause notices from tax authorities. These valuation experts issues certificates to startups on their revenue projections. The valuation is calculated on this basis according to the tax authorities. The notice was served to values when these startups failed to:
- To realize the revenue expectations
- Achieve the growth rate
The valuation increases and the revenue remains constant. (refer to scenario II in the next section)
What is Fair Market Value? And how is it calculated?
The Fair Market Value is the actual value of the startup/company. The FMV could be calculated by two methods:
- DCF(Discounted Cash Flow): the approximate future earnings i.e. the future cash flows
- NAV (Net Asset Value): assets owned by the startup/company
The current government considers FMV calculated on DCF(Discounted Cash Flow) projections.
Let’s consider situations for valuation which received notices:
Scenario I: Valuation decreases
The valuation of the startup decreases over time
Say a start-up raised funds at INR 100 per share in series A funding.
It now requires additional cash for purposes like- expansion or working capital requirements, which are common in start-up companies.
To meet this requirement, it raises Series B funding from a domestic investor. At the time of raising funds, the competition increases and government tighten policies. They raise funds at INR 80 per share. In this scenario, the valuation of the company reduces during Series B funding.
In this case, the Income Tax Department takes the additional INR 20/share in the first round- as income. This additional income of INR 20/share is now taxed at 30% under ‘Income from Other Sources’.
Scenario II: Valuation increases
The valuation increases, but the revenue remains constant
The sector in which the startup operates receives incentives from the government for R&D. This indicates that the government is supporting the sector. As a result of such policies, investing in businesses functioning in a particular sector becomes more attractive. This, as a result, can boost startup valuations, even when the revenue remains constant.
However, the startups are valued based on the negotiations. The valuations are subjective depending on the investor and the opportunity they see.
Response to Angel Tax
The news on angel tax was received with outrage from the startup and investor community.
To protect the startups against “Angel Tax” i.e. section 56(2)(viib), the IVCA(Indian Private Equity and Venture Capital Association) had recommended the government
- To “automatically shield” DIPP (Department of Industry Policy and Promotion) registered startup against Section 56(2)(viib), “Angel Tax
- Without a limit on funds raised via non-promoter capital
- Or, received funds less than INR 10 crore, including premiums and paid-up share capitals.
2. To “automatically exempt” investments made by
- HNIs(High Net Worth Individuals) in association with AIF(Alternative Investment Funds) registered with exempt investors like SEBI.
Founder of Sellerwrox, Ganesamurthi G received notice in 2017 to deposit INR 1 crore as tax on the $1 million funding it received from Axilor and Kris Gopalakrishnan’s trust. The notice was received a year after he shut his start-up. His case was still not resolved.
The startups demands in the angel tax controversy
- Exemption for the startups which are DIPP level 1 registered
- Create a process, through which these startups can submit additional financial documents like customer contacts, payroll, etc. this would prove that they are genuine startups and not shell companies.
Steps taken by the government
The recent notification by the government provided an exemption for angel tax when:
- Raised the cap for revenue to INR 50 lakh from INR 25 lakh
The startups can apply to the DIPP with supporting documents- financials and details of investors. Within a time frame of 45 days, the CBDT will decide if they are eligible for exemption or not.
Impact on the start-up ecosystem in India
Angel Tax and its fear might negatively influence the growing start-up base to move their headquarters to another country with favourable jurisdiction. The founder of Angel investor network Saurabh Srivastava said-
Angel investors are not interested to invest in startups in India and would consider investing only if they move outside India.
Around the world, nations are easing the norms to attract companies for setting up their headquarters.
Countries like Chile and Estonia are offering startup visas and programs, it allows them to establish their headquarters. It also permits them to easily access foreign markets and territories like the EU(European Union).
Countries like the U.S, Singapore, U.K offer tax-breaks to angel investments and investors. Indian entrepreneurs are also looking at countries which offer government funding, access to neighbouring markets, zero-taxes and minimal-rent to relocate.
Startups moving out of India will create higher pressure on the labour market. Since there would be low employment generation, therefore
More Job Seekers for a limited number of Job opprtunities
When these Startups mature to become companies, they will be earning incomes and profits, which are taxable. The loss in tax revenue from companies which will evolve from startups, when they mature.
Moving having their headquarters outside India might restrict their liability to pay taxes in India. This would lead to a loss of tax revenue for the government, a few years down the line.
Over the past few years, the startup ecosystem in India has flourished, developing ‘Unicorn’ and soon-to-be-Unicorn startups. Steps like angel tax might hinder this progress. The government must also consider that the initial funding of the startup idea is done through bootstrapping or friends and family of the entrepreneur. The incorporation and registration of the startup are done at a later stage.
Read more on Relief from Angel Tax!!! Is it Enough?
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