Angel tax is on the difference of fair market value and face value, but methods of determining fair market value is flawed.
There may be a sense of relief among startup founders who received tax notices on angel funding earlier this year. According to a The Times of India report, the government is considering additional sops and, possibly, redefining the term startup.
However, it will not solve the problem the way it didn’t when the Department of Industrial Policy and Promotion (DIPP) issued a notification last month, saying that the proposed changes were to “ease availment of angel tax exemption”. Now the Government intends to form a working committee to look into the ‘definition’ of a startup.
To be sure, the problem is not with the definition of a startup. The core of the ‘angel tax’ issue is the way Income Tax Act defines fair market value. According to Section 56(2) (viib) of the Income Tax Act, the difference between the fair market value and the face value of shares issued by a company should be taxed. Investments from venture capitals and Central Government are excluded. On the face of it, it is simple and logical. Now comes the tricky part: the fair market value would be determined by the assessing officer based on methods prescribed. This leaves the scope of interpretation.
Angel tax was initially proposed to arrest money laundering, but has not helped. Anyway, investment from domestic sources is still low. Domestic capital inflow to startups – a reason cited behind Income Tax Department’s move to send tax notices – is estimated to be at around 10 percent of $38.5 billion of total funding raised by startups.
Thus, the government should first resolve the issue of fair market value. Globally, investors follow different methods of determining valuation. Medium listed nine widely followed methods. Considering the fact that investments in a startup start coming at the concept stage, usually before it starts operations, the valuation process is complicated and is normally a price negotiated between the investors and the startup’s founder.
One of the issues pointed out in the Times of India report is that the government may raise the tax break limit for startups who have raised Rs 25 crore in aggregate from Rs 10 crore.
There are two issues here. Firstly, Rs 25 crore isn’t a big amount even for a startup, considering the fact that some in the recent past raised billions just to stay afloat even before they start generating profit.
Secondly, as of now, only people with more than Rs 50 lakh annual income and net worth of Rs 2 crore can freely invest in startups. This needs to be changed as well. To make the government’s StartUpIndia Mission grow and make India a safe bed for inception and execution of startups, the means and ways of funding should be liberalised.
All the above issues are making this difficult. For example, the inflow of seed capital or angel investments has dropped by more than 20 percent during January-September 2018, while overall startup funding has almost doubled to $4 billion during the same period.
It would be advisable that the government does away with the concept of ‘angel tax’. This would help India grow faster as a startup hub – referred to as the second in the Interim Budget on February 1, generating more jobs in a country where the unemployment rate is at a 45-year high. In an earlier piece, this author had pointed out that the way ‘angel tax’ is being taken forward, the government seems to be implementing an ‘investment tax’ in the guise of ‘income tax on angel investments’.However, the only relief is that the government has asked the income tax department not to take any action on the companies that have been sent notices (73 percent of the startups who raised money got notices). But, no one knows how long that would last.