By Siddarth Pai
As angel tax comes back into focus, the tax department has finally issued new rules intended to provide clarity. Many investors had put their investment decisions on hold as they didn’t want their investments being subject to such a tax at the hands of the company.
Introduced in 2012, Section 56(2)(viib) is an anti-abuse measure intended to “prevent the generation and circulation of unaccounted funds”. 56(2)(viib) taxes the difference between issue price of unlisted shares and their fair market value as income in the hands of the company. This innovation of converting investments, i.e., capital receipts, into income is uniquely Indian and has no parallel across the world.
This section was titled “angel tax” as it was primarily applied on early-stage start-ups that raised capital from high net-worth individuals, family offices, etc (also known as angel investors).
The preponderance of domestic capital in early-stage investments led to the term “angel tax”. It is more appropriately a “capital tax” as it taxes investments. The Indian start-up story has largely been funded by foreign capital, and bringing them under its ambit has frozen start-up funding this year.
The notification does offer some relief:
1. Foreign investors can now avail of five different valuation methods, not just net asset value and discounted cashflows;
2. If a Sebi/IFSCA-regulated AIF invests in the start-up and the start-up issues raises an equal amount of money from other investors at the same price, then the matching amount will not attract angel tax (viz. if a start-up raises Rs 10 crore from such AIFs, then another `10 crore from others will not attract angel tax. Any amount above Rs 10 crore from others may attract angel tax);
3. Compulsory Convertible Preference Shares—the investment instrument of choice—is also now covered by these regulations;
4. Variation of 10% between the fair market value and the issue price is acceptable.
But the issue at the heart of angel tax remains unresolved—that is, comparing projections to actual performance and taxing the difference. Contrary to the bureaucratic belief, start-up valuations are not driven by a valuation report.
Noted valuation experts like NYU professor Aswath Damodaran has stated “Young companies are difficult to value for a number of reasons. Some are start-up and idea businesses, with little or no revenues and operating losses. Even those young companies that are profitable have short histories and most young firms are dependent upon private capital, initially owner savings and venture capital and private equity later on. As a result, many of the standard techniques we use to estimate cash flows, growth rates and discount rates either do not work or yield unrealistic numbers.” Thus, adding more valuation methods does not resolve the issue.
It is widely known that the notices sent out by the tax department to loss-making start-ups through CASS (Computer-Aided Selection of Cases For Scrutiny) ask for the valuation report and the audited financials of the start-up. The officer then compares the projections in the valuation report against the actual performance in the audited financials and taxes the difference if it is substantial. Missing projections is a commercial risk, not a case to expose a company to tax. This translation of capital to income is unique to India alone and has been at the heart of angel tax for the longest time. Early-stage companies suffer the most due to the high degree of uncertainty inherent in their models.
Furthermore, differentiating between the valuation methodologies for domestic and foreign investors just increases the compliance burden. An Indian start-up, while raising capital, has to:
1. Obtain three valuation reports for three different laws (Companies Act, FEMA, and Income Tax)
2. from three different valuation professionals (registered valuers, CAs and merchant bankers)
3. using three different valuation methodologies
Adding a fourth valuation methodology does not ease this major bottleneck in the ease of doing business. There is no rationale to deny resident investors these new methods and reduce compliance burden on start-ups.
Furthermore, if an AIF participates in a financing round at the same terms and same price as other investors, why is only an amount equal to the AIF investment safe from angel tax? To illustrate, if an AIF invests `100 crore and a foreign investor invests `150 crore, only `200 crore would be exempt from angel tax despite the remaining `50 crore coming from the same investor whose investment is partly exempt.
To solve these issues, the department should look at making two important changes:
1. Clarifying that missing projections should not trigger angel tax, and the tax officers should look at other criteria such as investor pedigree, if any suspicious transactions have happened, if the spend has been for business or other reasons, etc;
2. If an AIF participates in the round, then the issue price should be considered as the fair market value and not capped at the amount invested by AIFs.
Angel tax was inserted to “prevent the generation and circulation of unaccounted funds”, as per the 2012 Budget Memorandum.
It was never conceived of as a tax-harvesting section and it should not become one. Nobody from the start-up industry would like to hamper the government’s fight against black money. But due care must be taken to ensure that Indian start-ups do not suffer unintended consequences and become collateral damage in the fight against black money.