RAKESH SHARMA
Moneycontrol Contributor
In a move that could reduce the negative impact of angel tax on the startup ecosystem, the Ministry of Commerce and Industry, on the 19 February, widened the definition of a “startup,” perhaps making it easier for investors to invest in these companies. Today, we elaborate on this very move. What is a startup according to the government? What is angel tax? What are the new changes made by the government? And how does the industry perceive these changes? All these on our Pick of the Day, with me Rakesh Sharma, on Moneycontrol.
The New Startup Rule Book
“With this notification, the definition of Start-ups will be expanded. Now an entity will be considered as a Start-ups upto a period of ten years from the date of incorporation and registration in place of the earlier duration of 7 years. Similarly, an entity will continue to be recognised as a Start-ups, if its turnover for any of the financial years since incorporation and registration has not exceeded Rs. 100 crore in place of Rs. 25 crore earlier,” said the notification from the Ministry. The government has also raised the tax exemption limit for startups with consideration received for share issuance not exceeding Rs 25 crore. Earlier the limit was Rs 10 crore.
So, you are a startup until you are ten years of age, and you are still a startup if your turnover does not go beyond 100 crore rupees. And tax exemption limit has gone up from 10 to 25 crore rupees.
Now the question of angel tax. Under the IT Act, Section 56 (2) (viib) money invested by angels in a company is treated as income from other sources. Priyanka Sahay, writing for Moneycontrol, noted that many startups who raised angel investments in assessment year 2015-16 and 2016-17, received notices from the Income Tax department under this Act. One survey conducted by LocalCircles and the Indian Private Equity & Venture Capital Association (IVCA) found that 73% of startups that raised capital between Rs 50 lakh to Rs 2 crore in India had received angel tax notices from the Income Tax Department till January.
Minister Suresh Prabhu took up these issues in a roundtable on the 4th February 2019 under the chairmanship of Secretary DPIIT with Startups, angel investors, and other stakeholders with a view to discuss the new measures undertaken by the Department to address the Angel Tax issue and understand the mechanism to deal with it institutionally.
Under the new rules, in order to receive the recognition of a startup, the startups will have to make an online application to Department for Promotion of Industry and Internal Trade (DPIIT). The application will need to have a copy of certificate of incorporation or registration and a write-up about the nature of business highlighting how it is working towards innovation, development or improvement of products or processes or services etc. The DPIIT after making some inquiries will then either recognise the eligible entity as startup or reject the application by providing reasons.
As the per new notification, investment from non-resident Indians as individuals, alternative investment funds (category I) and listed Indian companies with net worth of at least Rs 100 crore (or turnover of at least Rs 250 crore) have been exempted from the angel tax net. Alternate investment funds- Category I registered with SEBI will be exempted under Section 56(2)(viib) of Income Tax Act beyond the limit of Rs 25 crores.
According to the press release, a startup will be eligible for exemption if it is a private limited company which is recognized by DPIIT and is not investing in building or land appurtenant thereto; land or building, or both, not being a residential house; loans and advances, other than those extended in the ordinary course of business; capital contribution made to any other entity; shares and securities; a motor vehicle, aircraft, yacht or any other mode of transport, the actual cost of which exceeds ten lakh rupees, other than that held by the startup; and jewellery other than that held by the startup as stock-in-trade in the ordinary course of business. So no splashy car if you have a new startup. No yacht either. Okay? Okay.
As we have noted in another piece discussing the startup scene in the country, there are about 39,000 startups in India; 30,000, according to some other estimates. However just around 16,000 startups have DIPP- level 1 recognition and as of November, just 91 startups were approved by the government for availing tax benefits. Earlier in February, the government had set-up a small working group comprising of angel investors and startup founders to look into issues faced by angel investors. This meeting was the outcome of incessant protests by investors in the last few weeks following the government's angel tax notification on January 16. Which brings us to a quick tutorial on what angel tax is all about.
Angel Tax: Devil in Angel’s Name?
Gautam Nayak, a chartered accountant, writing for Mint, asked a very valid question: “How would you feel if you were to invest your tax paid funds into shares of a recently set-up company, and that company has to pay one-third of that money by way of income tax, though it is a loss-making company?” Nayak said, effectively, you are losing one third of the value of your investment immediately. This is the problem of the Angel Tax, and one that has been raging in the startup ecosystem for a while now.
Introduced in the 2012-13 union budget by then finance minister Pranab Mukherjee, angel tax is levied on start-ups that have received equity infusion in excess of the fair valuation, with the premium being paid by investors as their income. That could sound confusing, so Gautam Nayak explains it a little more vividly: “[Angel tax] is a provision under which a company is taxed if it charges a premium for its shares, where the amount received for allotment of the shares exceeds the fair market value of the shares. As is well known, many loss making companies, including e-commerce companies, tech start-ups, etc have high valuations, though they are currently incurring losses. These valuations are based on rosy future projections, assuming that the idea underlying the business will succeed. By the time the tax assessment comes up, in 9 out of 10 cases, the projections are not met. The tax officer, on the basis of hindsight, then refuses to accept the valuation, and values the company based on figures actually achieved. This results in large amounts of share premium being treated as income of the investee company.”
Introduced in Section 56 of the I-T Act in Budget 2012, it explicitly stated that companies - from mature private enterprises to small startups – are liable to pay taxes on money invested at capital. Considering most startups take years to even start breaking even, treating money that came in from angel investors as taxable income seemed a rather draconian idea, and one that the startup ecocsystem, perhaps rightly, railed against.
DPIIT Secretary Ramesh Abhishek said, “We have gone far beyond angel tax issues. Angel investors generally put in around Rs 3, 4 or 5 crore. The new Rs 25 crore limit is much more than that and will cover all investments by promoters, their friends, relatives and batchmates. Also, all investments made by listed companies into start-ups are without any limit. Their investment will not be considered part of the Rs 25 crore. This will encourage more Indian investments and Indian ownership.”
The new rules, to the extent they address the angel tax issue, have been welcomed. “The blanket exemption from angel tax for startups is a welcome change for the industry as it would make it easier for indigenous innovation to thrive in our country,” said Ankit Mehrotra, co-founder and chief executive of Dineout.
Saurabh Srivastava, Chairman, Indian Angel Network welcomed the move as the beginning of a new wave of entrepreneurship in the country. “I am delighted that the government has, in effect, abolished angel tax for startups. Kudos to DIPP for their leadership and to MOF/CBDT for collaborating to make this happen. Angel tax had begun to dampen the enthusiasm of angel investors and startups, who had begun migrating abroad. Today’s announcement will move India from third place to the number one startup nation in the world. This will transform India’s economy,” he said.
Hailing the move as revolutionary in its essence, Padmaja Ruparel, Co-Founder, Indian Angel Network (IAN) & Founding Partner, IAN Fund said, “This will unshackle angel investing and bring in domestic monies for startups and help create the New India. The message that the government has given is that India will not only be the world’s startup hub but startups which can go global, by increasing the turnover from Rs. 25 crores to 100 crores. This is a seminal move for angel investing and the foundation of Startup 2.0.”
Atul Pandey, partner, Khaitan & Co. said, “The changes, in total, are a welcome move, for start-ups ... by ensuring that greater number of startups are able to avail of the exemptions, as well as facilitating investments by domestic investors without the apprehension of tax levy. The changes introduced will also alleviate the government’s concerns to a certain extent regarding shell companies evading taxes under this route, while allowing exemptions for startups.”
Problem Kyaa Hain?
Sounak Mitra, writing for Moneycontrol, addresses a few concerns about the new rules. He says, “The rule barring startups from investing in securities is going to hurt the entire ecosystem. As VCCircle pointed out in a report, most of them “temporarily park” raised funds in “debt mutual funds” until they need to use it. No company would require all the money raised in one go. But, investing them in any securities-linked instrument would debar them from availing angel tax exemption. Besides, there is no clarification on what would happen to the interest they might earn if they just put the funds in bank.”
The lack of details about investor profile is also something to pay attention to. According to the earlier definition, only people with more than 50 lakh rupees of annual income and net worth of 2 crore rupees will be eligible to invest. But Mitra believes this is restrictive to small investors, especially individuals. He says, “[…] most ventures start with investments or loans from friends and family members. This is one area that the Government needs to have a relook and liberalise it so that StartUpIndia Mission gets a boost and the country is in a position to become the incubation bed for innovative startups.”
While the increase of turnover threshold from 25 crore to 100 crore is a welcome move, experts also believe that this would only benefit larger startups. Many of these sops will require greater tweaking of the Income Tax Act to be beneficial in any real sense to the large majority of startups, and those amendments show no signs of arriving any time soon.
As S Vasudevan, partner, Lakshmikumaran & Sridharan Attorneys, said, “No relief is proposed in respect of Section 68 of the Income Tax Act, 1961. So start-ups will continue to carry the onus to establish the genuineness of the source of the investment made by investors, failing which the sums received on share application can be taxed by the department.”
While the devil of the angel tax has been exorcised by this move, it appears the proverbial devil does live on in the details. The government has been keen on arresting money laundering, and has believed for a while now that startup funding could be a channel for it despite the lack of any evidence linking the two. Perhaps it just wanted to make some noise, and angel tax was the form that noise took, to establish just how stern the dispensation is with regards to illegal financial activity. (Sure, let’s forget that the banking sector scams didn’t happen; let’s roar instead about money laundering in startup funding. Bhai wah!)
India is the third-largest startup ecosystem in the world with more than 50,000 ventures launched in India creating $130 billion of value and raising $38.5 billion between January 2014 and September 2018. That said, of the 26 unicorns and 30 soonicorns, a third are headquartered outside India. Of all the investments into these companies, about 10% came from domestic capital. (according to Mohandas Pai, on BloombergQuint).
To revolutionise the startup economy in India, and to ensure that the country does not merely end up becoming a “digital colony,” with the fruit of the country’s best’s efforts benefiting mostly foreign nationals sitting far away, much more needs to be done. While the Government’s latest move on the issue of angel tax is a step in the right direction, the fineprint has not been palatable to a large section of the startup community.
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