Explained: Angel tax will damage India’s entrepreneurial ecosystem

New Delhi | Updated: Jan 19, 2019 7:16 AM

Section 56 of I-T ACt Will cause disastrous collateral damage to India’s entrepreneurial ecosystem, given it is an Unjust Levy on genuine sTart-ups.

start up, start up sector, start up industryThe government’s recognition of start-ups as a key engine of job creation and economic growth was very welcome.

By Saurabh Srivastava

If India doesn’t create 12 million jobs a year, our much touted demographic dividend will become a demographic disaster. And global data is conclusive that neither governments nor big business can make this happen. The respected Kauffman Foundation, based on data over a 40 year period, found that (except for 7 years in between), all net new job growth in the US came from start-ups.

The government’s recognition of start-ups as a key engine of job creation and economic growth was therefore very welcome. The PM himself, DIPP, Niti Aayog, and even SEBI, have led from the front with a slew of measures to create an enabling environment for start-ups. This has unleashed unimaginable energy and today India is the 3rd largest entrepreneurial hub in the world with 26,000 start-ups. Besides creating lakhs of jobs and attracting billions of dollars of global capital, these start-ups are also creating innovative solutions for India’s many challenges in affordable healthcare, education, agricultural productivity, clean energy, water, sanitation, etc.

But the Devil lurking in what could have been a Garden of Eden is the infamous “Angel Tax”, which threatens to undo all the good work done by the government so far. Introduced in 2012, Section 56(2) (viib) of the income tax (I-T) act taxes as income any investments made by an Indian entity in an unlisted Indian company above fair market value (as determined by the assessing officer (AO)), giving India the dubious distinction of being the only country in the world to do so. Surprisingly, investments by overseas entities are exempt!

Hundreds of I-T notices have gone out to start-ups already battling the twin challenges of global competition and availability of funds. Some prolific and iconic angel investors have received scores of I-T notices as well, asking not just for the PAN number but also the detailed computation of income, full year bank statements for all bank accounts and various other documents normally provided to an AO for scrutiny. Rather than face such harassment for a `10-20 lakh investment in a start-up, many angel investors have stopped investing and several start-ups are locating abroad to raise monies from the same investors without this tax .

This has tragic consequences for India as angel investors are the first “non family and friends” investment in a start-up and provide the valuable mentoring and market access which often makes the difference between success and failure. In the US, in a typical year, VCs invest around $25 billion in 5,000 companies whereas angels invest ~$26 billion in 50,000 companies, creating the ideal entrepreneurial pyramid where 1 in 10 companies makes it to the next level but needs 10 times the money.

The problem with “Angel Tax” is that start-ups generally have no profits, often no revenues and virtually no assets. Savvy angel investors value them based on the deemed value of the idea, the possible market size, the quality of the founders/team, their passion, etc. Rarely do two investors agree on a valuation. In this world, any prescriptive valuation norm is pointless. AOs, ill equipped to value companies with negligible/negative book, inevitably tax the investment as income which makes Section 56 the most entrepreneur-unfriendly legislation in the world, forcing start-ups to raise 50% more money than they need (to pay 33% tax) and suffer unnecessary, excessive dilution.

And all this for what? Angel investments, while creating the nurseries of thousands of start-ups which VCs and global corporates build into Flipkarts, Olas and Paytms, are barely a few hundred crores. Angel tax collections, if any, would be barely `30 crore, far less than the administration and litigation costs that would be incurred by the government and start-ups.

DIPP must be complimented for tirelessly batting for start-ups and the latest announcement by the commerce minister significantly improves the process and will help alleviate some of the stress being faced by start-ups and angel investors. However, in the highly frenetic pace of the start-up world, which needs laser-like focus on the business to compete with counterparts in China and other countries (which are doling out investments and incentives in contrast), start-ups will struggle with the time, energy and resources needed to deal with the bureaucracy and administrative overheads that any case-by-case method entails. The real solution is to relook Section 56.

Ostensibly, the amendment was put in place as some politicians were starting companies and raising money at a premium from people who benefitted from their largesse. But corrupt payments cannot be prevented using tax laws as the corrupt will find another way to pay.

It is the corruption act that needs to be tackled, not the payment mechanism. Section 56 is indeed a flawed legislation as its seeks to “lazily” tax (thus legitimise) an illegal transaction rather than prosecute it.

And, by being applied inappropriately and indiscriminately to genuine start-ups, it is causing unintended but disastrous collateral damage to India’s entrepreneurial ecosystem. Jettisoning the age old Indian bureaucratic tradition of throwing out the baby with the bathwater by legislating for the 1% who abuse rather than the 99% who don’t (killing everyone in the bargain), the CBDT must either scrap Section 56 or draft it better to exclude genuine start-ups and angel investors. It must recognise that this “angel tax”, which it believes is its right (but is willing to exempt under certain conditions), is considered an unfair, unjust and illegal tax by all start-ups and investors in India, and in every country in the world. After all, no country in the world taxes angel investments and we don’t live on another planet!

The government can take a leaf out of its own book. In 1991, when our fledgling $100 million software industry, comprising of 99% start-ups, was struggling to compete globally, with no access to angel investments, venture capital or bank debt, the government took the highly visionary step of providing 100% tax exemption (Section 80 HHE) to an industry which had only intangible products/services with a huge risk of abuse/fraud/black money. There were a handful of frauds, Satyam being the big one, but the payback changed the fortunes and the brand image of India. IT is now a $180 billion industry, paying billions in corporate and personal taxes, accounting for 25% of forex earnings and employing around 14 million people (directly and indirectly), making it the largest employer in the organised private sector. Start-ups will do all of what the IT industry did but, while the IT Industry still solves largely global problems, they will also solve Indian problems. It would be tragic if, for a few pennies and a lack of vision, we miss the best window we have had in a few hundred years to go back to being 25% of global GDP.

The author is co-founder of NASSCOM, Indian Angel Network & TIE NCR

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