India is the second biggest hub for startups in the world in terms of number of businesses. While the Narendra Modi government has the stated aim of promoting entrepreneurship in the country, the startup sector is now smarting under tax scrutiny which it says is unnecessary and harmful for its financial health. Angel tax, levied on angel investment in startups, has been in news recently for tax notices slapped on a large number of startups and the the sector demanding remedies.

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 realisation is treated as income and taxed accordingly. The tax was introduced in the 2012 Union Budget by then finance minister Pranab Mukherjee to arrest laundering of funds. It has come to be called angel tax since it largely impacts angel investments in startups.

How it impacts startups

The share issued to an investor has to be valued to decide whether the price is in excess of fair value. The industry has demanded that the discounted cash flow (DCF) method of valuation be used to calculate angel tax instead of the net asset value (NAV) method, though even that may not capture the true value of a startup. 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.

The latest trigger

A large number of startups have received notices to pay angel tax. Many founders have said they have been asked to pay up as much as 30% of their funding as tax. Angels have also received multiple notices asking them to furnish details on their source of income, their bank account statements and other financial data. Procuring valuations from merchant bankers is also a more expensive proposition for startups than going through chartered accountants. For those who have been issued notices, charges are piling up for chartered accountant fees for filing an appeal. The government has said no coercive action will be taken to recover the demand and has set up a committee to review the entire issue.

A recent survey by community social media platform LocalCircles and the Indian Private Equity & Venture Capital Association (IVCA) showed that more than 2,000 startups that had received funding from investors– angel financiers, private equity and venture capital funds–have received angel tax notices. That’s about 73% of the 2,883 respondents.

What the government did

Interim Budget 2019 was expected to address the problem of angel tax on startups but did not. Last month, the government liberalised the conditions for startups and investors to shield them from angel tax. The new regulation provided for simpler mechanism for startups to claim exemption from this tax even for past investments, including for startups incorporated before April 2016, the cut-off date for incentive under the startup policy announced by the government. Startups, whose aggregate amount of paid up share capital and share premium does not exceed Rs 10 crore after the proposed issue of shares, are eligible for angel tax exemption.

Big relief coming?

The big relief, which was expected in Interim Budget 2019, is likely to come next week. According to reports, the government is contemplating hike in the investment limit for availing of income tax concessions by startups and provide a more clear definition for the purpose. After discussions with various stakeholders earlier this week, the Department of Industrial Policy and Promotion and Central Board of Direct Taxes are believed to have accepted some of the demands of startups which could be notified next week. Though startups are demanding complete exemption from this tax, the government might increase investment limit for tax exemption between Rs 25 and Rs 40 crore. The current limit is Rs 10 crore. The exemption could come with the condition that startups submit an undertaking that they are not shell companies and are not used to launder black money. The government is also likely to recognise all companies that are in operation for up to 10 years as start-ups instead of the current limit of seven years.

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