Angel tax: Not dead, merely deferred

Published: August 26, 2019 12:55:28 AM

If the intention is to bring relief, then the February 2019 circular should be amended to state that loans and advances in the ordinary course of business should be allowed provided the PAN of the recipient is provided.

The negative list includes land, building, motor vehicle, aircraft, yacht, jewellery held by then, other than in the ordinary course of business.

By Siddarth Pai

Never has a tax displayed the flagrant disconnect between the bureaucracy and business like the angel tax does. In the measures to boost the Indian economy announced by the finance minister last week, angel tax found an explicit mention, causing entrepreneurs to rejoice that this ordeal is over. But the devil lies in the details, and the angel tax isn’t dead—it is simply deferred.

Angel tax, or section 56(2)(viib) of the Income Tax Act, 1961, was an insertion by the UPA regime in 2012 as a means of checking the circulation of unaccounted funds through investments into private companies. It sought to attack “high share premium”—a supposed smoking gun of money laundering; instead, it turned out to be a red herring. A high share premium is the consequence of the mathematics underpinning valuation. Simple, legitimate corporate actions like having a small initial capital base and having a low face-value (both mainstays of any technology start-up) can translate into high share premiums. It is no more an indication of money laundering than having high-speed internet is an indication of online piracy.

The reason for this link between high share premium and money laundering arose from details uncovered by the Enforcement Directorate against Jaganmohan Reddy, where it was discovered that people had “paid bribe to Reddy in the form of investments at exorbitant premiums in his various companies to the tune of `779.50 crore, apart from making payment of `57 crore to him in the guise of secondary purchase of shares and donation of `7 crore to YSR Foundation”. It was from here that the indelible link between share premium and unaccounted money was cemented in the minds of the tax officers.

The unintended consequence of this 2012 legislation was that it became a tool of harassment of start-ups in the hands of the taxmen. Indian start-ups raise between $12-14 billion of capital every year, with only under 10% of it coming from domestic sources. The bulk of domestic funding comes at the “angel” or “seed” stage—where the risks are the highest. All of them are valued by investors based on their potential and projections, not their present. Due to the factors mentioned above, all these securities were issued at a premium. It is this premium—this mathematical outcome that the taxmen attacked with vigour, raising demands of 30% of the share premium raised by the start-ups. It is no secret that these start-ups were easy pickings for taxmen, who were under pressure to meet collection targets.

Worse, it targets the money from Indian investors alone; no other country in the world has so actively discriminated against its own citizens in their own country. Not even the British would have inserted such a provision in the pre-Independence era.

Over time, with the concerted effort of the media, entrepreneurs, business leaders, DPIIT and the politicians, the tax department drip-fed circulars to address parts of this issue—tilting at windmills instead of tackling the bull by the horns. But in February 2019, there was finally a breakthrough wherein this scourge of angel tax could finally be put to rest. The circular stated that all start-ups would be exempt from the tax provided they don’t make any investments into a negative list for seven years from the date of issuing shares at a premium. It is within this list that the Achilles heel of the angel tax exemption lies.

The negative list includes land, building, motor vehicle, aircraft, yacht, jewellery held by then, other than in the ordinary course of business. All reasonable asks as those are assets that do not contribute to general business, and if it does, it is permitted. But, it is pertinent to note that this carve-out in the ordinary course of business doesn’t apply to three areas: loans and advances, shares and securities and capital contributions—and therein, as the bard wrote, lies the rub.

Loans and advances: Loans and advances are such an integral part of a business that the format of financial statements mandated by the Company’s Act gives detailed instructions on its presentation in a balance sheet. Some of the constituents include security deposits like rental deposits, down-payment on assets, advances to vendors, salary advances, loans to employees for purchasing ESOPs, salary advances and even advance tax.

None of these by themselves are indicative of money laundering and all these are legal under all laws except the angel-tax exemption. What is more surprising is that discharging one’s advance tax liabilities can potentially deny the start-up angel tax exemption! A more ironic example of cutting the nose to spite the face is yet to be found.

Investments in shares, securities or making capital contribution: On the face of it, one can question why a startup would need to deal with shares and securities at such an early stage, a reasonable ask since the money raised can be invested into other entities, thus perpetuating the laundering of cash. But what the authorities fail to realise is that this hampers business productivity since it effectively bans all joint ventures, subsidiaries, stock mergers and acquisitions and treasury management! No longer can a company expand by setting up subsidiaries in other geographies or joint-ventures with other businesses. Stock M&A, which forms the bulk of consolidation in various sectors, is effectively killed since this would transgress the exemption. Treasury management, wherein companies park excess funds in short-term money-market listed instruments regulated by SEBI, is now taboo.

The most pernicious part of this list is that it this moratorium should continue for seven years after the year in which shares were issued for a premium. So, the argument proffered that a young start-up has no business engaging in such investments is myopic. In the guise of an exemption, the circular places a glass ceiling on growth and ordinary corporate activities. The choice for Indian entrepreneurs is now to either raise domestic capital but sacrifice competitiveness or raise only foreign capital and be exempt from these restrictions. The message from the tax department seems to be that one can start up in India, make in India, too, but if you’re Indian, please don’t invest in India.

For those who may label this as alarmist, there are already situations faced by entrepreneurs wherein the assessing officers are questioning the exemption on the basis of these weak links. Worse off, the new Finance Act inserted a penalty of 200% of the premium in case a start-up has its exemption revoked. Recent notices received by entrepreneurs as early as last month are asking start-ups to justify the fair market value of the securities without mentioning Section 56(2)(viib) —a clear indication that this issue hasn’t died down, it has simply mutated to a more pernicious form. Even the recent notifications state that any tax officer can only open up proceedings on “Angel Tax” with the prior permission of their superior officer isn’t relief, it is bureaucracy with extra steps.

If the intention is to bring relief, then the February 2019 circular should be amended to state that loans and advances in the ordinary course of business should be allowed provided the PAN of the recipient is provided. On the issue of investing in shares and securities, if it’s made into SEBI registered entities, then it should be allowed. Furthermore, any subsidiary or joint-venture should be precluded from investing in land, jewellery, buildings, etc—thus, plugging the gap that allows the start-up to be used as a via media to make banned investments.

The finance minister spoke about angel tax in the budget—the first time it was mentioned by name in any budget speech since 2012—and stated that it has been dropped for registered start-ups. But unless these issues are resolved, this is a time-bomb waiting to explode. The devil is always in the details, not in the headlines—and the angels are nowhere to be found.

Founding Partner, 3one4 Capital
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