Income Tax Taxation

Angel tax – Its Effects on Indian Startups

India is the second-biggest hub for any startup to grow and set up its business. The Indian government is also promoting such startups and entrepreneurship in the country. Recently, angel tax has been in the news which is levied on angel investments in startups. The tax notices are issued to a large number of startups and hence such sector demand remedies.

In this article, we will explain more about the India Angel tax mechanism and its effects on the startups.

What is Angel Tax?

Angel tax refers to the income tax payable on capital raised by Angel Investors which are basically unlisted companies via the issue of shares where the share price is seen in excess of the fair market value of the shares sold. One of the difficult tasks for startups is to obtain funding. Normally the startups receive money only from friends and relatives. However, there is another class of investors who provide funding to these startups organization. They invest in companies which are in the early stage of development. These investors act same as the Venture Capital function. Hence these investors are named as “ANGEL INVESTORS”.

The Angel Investors take the risk of investing in Startups which in turn the government provides them various tax breaks for investing in startups. The United States has provided the Angel Investors the benefit of reinvesting the profits generated from one Startup to another startup. However, this facility is not provided in India. Angel Investments has not received much importance in India, the reason is that no special tax breaks are provided to the Angel Investors.

As per the latest Tax Laws the startups have to shell out 30% of the funding which they receive from Angel Investors as tax under the head “Other Sources Income” and will the taxed at the maximum rate. This demoralizes the Startups. Facing such issue, the Startups and the Investors have collectively filed an online petition to pressurize the government to abolish the taxes.

Motive of Angel Tax

Black Money is the biggest problem that India is facing. Also, out of the large population, only a few people are doing tax compliance. Presently around 2% of the population pay income tax and do their compliances properly. Thus, the Tax Department is worried if they support Angel Investment which will, in turn, increase money laundering.

Mostly the startups have their assets which are off the books of the company which the investors are aware of as such they provide them with high valuations. In this situation, the startups defend themselves by saying that by obtaining higher valuations they do not become an offender and it is not a crime. Also, they believe that they are not involved in any kind of money laundering nor they are involved in any case of tax evasion.

Due to these flaws, the tax department is of the view that the valuation of the startup’s companies has to be done by the specialist which is to be based on the predefined formula. This is will enable to calculate the valuation of the assets of the startups on the fair value basis. However, if the value exceeds the fair value then it will be subject to the highest level of taxation

What are the benefits of Angel Investment to Certified Innovative Startups?

The government of India has introduced this concept of Certified Innovative Startup which basically is a startup which has received certification as per which they are not subject to draconian angel tax which is torturing the startups and killing genuine innovation.

Thus, getting a certification is not an easy task. The Startups have to follow certain stringent parameters to get the certification:

For Example, A Company willing to apply for Certification must:

• Not have a turnover exceeding 25 million rupees and
• The startup should not be old than 5 years and
• The startup should be engaged in the production of innovative product or services

Problems due to the Certification parameters are:

• That the Parameters set are very subjective
• Also, various departments in India are also known for corrupt officers who manipulate the startups as such startups are reluctant to apply for the certification

As a result, approximately only 5% or fewer startups apply for certification and are able to get it. Now we understood the crux of the Angel Tax let me take you through the effects of Angel tax on startups.

See Also: All Types of Income Tax Return Filing In India.

Effects of Angel Tax:

1. The Angel Tax is interfering the market mechanism. As the investors are finding it difficult to finance based on the merits. As funding is mostly based on the certificates and the limits set by the government. The Makin in India concept introduced by our Prime Minister Narendra Modi is of no use if this is the criteria which are to be followed to get the funding.
2. The Indian Law probably the only law which taxes equity investment. All across the world, the equity investment is treated as capital through which profits are generated. However, in India Income Tax is to be imposed on the profits and not the capital itself.
3. The introduction of this Angel tax in 2012 has destroyed India’s startup ecosystem. In the five years since this tax has been introduced, the angel funding has seen a drop of over 55%. A number of companies being funded have dropped by 80% during the same period.
4. As a result of this large no of startup companies are forming their companies overseas. This is because foreign companies are providing startups with a favorable environment for selling their product or services. However, in India, the startups are getting hostile environment leading to lost taxation revenue from the legitimate income that the startups earn.
5. If the shares are issued at Fair Market value which is determined by the government it may lead to dilution of the promoter’s control over the startups. Startup as per definition is asset-light. They do not have the book value to justify their valuation. Their valuation depends on other soft factors like the people involved, the technology involved, etc. This is the case across the entire world and is not specific to India. When no other country in the world is taxing startups, the Indian government does not have a right to tax equity investments by considering it as income.

Recent Amendment:

The Government of India is continuously engaged in addressing the issues which are faced by the Indian Startup Ecosystem.

As per the notification issued by the Department of Promotion of Industry and Internal Trade (DPI) in April 2018 for easing the norms for providing tax exemptions to startups which were further amended on 4th February 2019.

As per the amended notification, an entity will be considered as Startup:

1. Up till 7 years from its date of Incorporation on to the off chance that it is fused as a restricted organization or enlisted as an association firm or a constrained obligation
2. Turnover of the companies any of the Financial year or from the date of its incorporation or registration has not exceeded Rs.25 Crores.
3. The main of the startup is to work for innovation, development, enhancement of items or procedures or administrations. Provided the element stated above it is pertinent to note that recreation of current business will not be treated as “Startup”
4. If the Startup wills to apply for the endorsement for the offers issued to proposed to be issued are required to fulfill the following conditions:
   • The total amount of paid-up offer capital and offer a premium of the startup after the proposed issue offer shall not exceed Rs. 10 crores.
   • The Investor od proposed Investor shall have:
     • Returned Income of Rs.50 lakhs or more for the financial year proceeding the year of investment or the proposed investment and\
     • Total Assets exceeds Rs. 2 crores or more which is proposed to be made in the startup

Provided that in case the approval is asked for offers as of now issued by startups no application will be made whether appraisal request has been passed by surveying officer for the important money-related year.

The application, accompanied by the documents specified therein, shall be transmitted by the Department of Promotion of Industry and Internal Trade to CBDT along with the necessary documents. CBDT^[1] within 45 days from the date of receipt of application from DPI may grant approval to the Startup or decline to grant such approval.

However, the Government has not conducted any survey to assess the adverse effects of angel tax on the Indian startup ecosystem.

See Also: The Amazing History of Income Tax in India- Read Now.