India is one of the fastest-growing start-up hubs in the world. It is currently home to about 39,000 active startups -- a five-fold increase from just a decade ago when the Indian startup ecosystem was in its infancy. Even so, startups continue to face regulatory and legal hurdles that impede their growth, despite the current Government’s Startup India initiative. In 2012, Section 56(2)(viib) was introduced in the Income Tax Act, which stipulated an ‘angel’ tax for unlisted companies. Since then, the angel tax and the methodology of its calculation have been subjects of controversy, and consistent opposition by startups.
The angel tax has come to be known as such because it primarily affects investments in startups made by angel investors (also known as seed investors, those who invest in early-stage startups). Introduced in 2012 as a measure against money laundering, it is essentially the tax levied on the capital raised by unlisted companies through the sale of shares where the share price is what the tax department computes as above the company’s fair market value. The excess capital raised is considered income and is taxable at 30%. The tax is applicable to funds raised by resident investors, but not non-residents or venture capital firms.
The opposition to angel tax from the startup community has to do with the principle on which the tax is based and the methodology used to calculate it. The Income Tax Department computes the fair market value of a startup based on its net assets. Startups argue that the valuation of companies should be decided using the discounted cash flow (DCF) method. This is because the method used by the I-T department does not take into account estimated growth and future projections of the startup, which are both crucial to determining the fair market value of a company, and therefore does not capture the true value of the startup. A 30% angel tax on investible surplus can gravely hinder the growth prospects for a fledgeling startup.
Given the constant scrutiny, criticism and backlash witnessed by the angel tax since its introduction, the Government has taken some steps to ease pressure on startups. Earlier this year, effective from February 19, the Government introduced a few changes to provide some relief from the angel tax burden.
One, it expanded the definition of a startup -- companies would be considered startups up to 10 years from the date of incorporation, up from 7 years, and therefore eligible for tax exemptions. Startups with annual sales of up to Rs 100 crore would also be eligible, up from Rs 25 crore previously.
Two, it raised the tax exemption limit. This change allowed tax exemptions on investments up to Rs 25 crore -- earlier, only investments up to Rs 10 crore were eligible for exemption. This Rs 25 crore ceiling was also waived off for certain investments, such as those made by listed companies with a net worth of Rs 100 crore or turnover of Rs 250 crore. The compliance process was also simplified, with eligible startups only required to submit a signed self-declaration to the Department for Promotion of Industry and Internal Trade (DPIIT) for claiming a tax exemption.
Most recently, what’s being discussed as a big respite for startups is the announcement made in the Union Budget 2019 on July 5, in context of notices sent from the I-T department to many start-ups demanding hefty penalties for non-compliance, sometimes exceeding the funding amount itself. The announcement stated that startups offering the requisite declarations and information on their returns, and are verified by the Government, will face no additional angel tax-related scrutiny by the tax department. Furthermore, the establishment of an e-verification mechanism was proposed, in order to validate the investor and the source of their funds, as was a “special administrative arrangement” by the Central Board of Direct Taxes (CBDT) for pending assessments of startups and redressal of grievances.
Many are lauding the regulatory easing for startups proposed in this Budget. Some investors and entrepreneurs are hopeful that these measures would inject new life into early-stage startups in the form of a renewed flow of capital. However, many believe that by retaining the angel tax, the Budget is merely assuaging a symptom of the problem, but not addressing the cause. There is also disappointment with CBDT’s “special administrative arrangement” as some believe that it would only reinforce bureaucratic meddling. Notwithstanding divided opinions, whether or not the Budget’s provisions with regards to angel tax will translate to a more hospitable regulatory environment on the ground for startups remains to be seen.
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