New “Angel Tax” Exemption Rule Does Nothing to Comfort Start-Ups

Start-ups have written to the prime minister saying that angel tax could “derail the Startup India initiative”.

Minister of Commerce and Industry, Suresh Prabhu, issued a notification that seeks to simplify the angel tax exemption procedure. 

(Photo: Kamran Akhter/ The Quint)

Start-ups are in distress and many feel victimised mainly due to the subjectivity, cost and arbitrariness involved in the implementation of this anti-evasionary measure which treats every assessee as guilty until proven innocent.

This desperate plea by 68 start-ups in a letter to Prime Minister Narendra Modi on 15 January not only illustrates the distress caused by ‘angel tax’, but serves as an indictment of the government’s various start-up initiatives.

Among the signatories to the open letter was Sreejith Moolayil, co-founder of TrueElements, a health foods start-up. “I got a notice from I-T officials in December 2017, asking me to pay Rs 40 lakh as tax on a Rs 1 crore angel funding I had secured in 2015. I was slapped with another notice in December 2018.”

A day after the letter was submitted to the PMO, the Ministry of Commerce, headed by Suresh Prabhu, on 16 January issued a notification announcing changes to section 56 (2) (vii b) of the Income tax Act, which imposes the ‘angel tax’.

However, the relief among start-ups was soon tempered once it emerged that the provisions of the notification did little to address the real concerns of the start-up ecosystem in India.

What Is “Angel Tax” ?

“Angel Tax”, at the heart of the discontent among start-ups, under Section 56(2) (viib) of the Income Tax (I-T) Act, taxes any investments made by an Indian entity in an unlisted Indian company above fair market value as income.

This levy, described as arbitrary by many, places the power to evaluate a company in the hands of Income Tax inspectors, whose valuation and methods are at odds with the start-up ecosystem and investors. It is a fact universally observed that even the most experienced venture capitalists get valuations right only once in 10 times.

This mismatch between how investors evaluate a start-up and how the Assessing Officer (AO) does so lies at the heart of the unrest and distress within the community.

Hundreds of start-ups that raised angel funding in AY2015-16 and 2016-17 have received notices from the Income Tax department. The notices question the high share premium at which the shares have been allocated during the funding.

“The tax inspectors only understand the asset-based evaluation of companies, whereas what should be followed is the Discounted Cash Flow (DCF) method, which takes into account future growth prospects. This is much more accurate for asset-light technology start-ups.”

Sreejith Moolayil, Founder, True Elements

Do the New Rules Simplify Angel Tax Exemption?

While the recent notification has been touted by the government as simplifying the process of seeking a retrospective exemption on taxes, the big question is, does it really do that?

As per the notification, certification from an inter-ministerial body for seeking exemption from angel tax has been done away with. Now, a start-up can fill up a form with the requisite documents and submit it to the Department of Industrial Promotion and Policy (DIPP), which will forward it to the Central Board of Direct Taxes (CBDT).

The CBDT “within a period of 45 days from the date of receipt of application from DIPP may grant approval to the Startup” the notification says. The reactions from the start-up industry, however, have ranged from disappointing to mixed at best.

While some see merit in the new circular with cautious optimism, Moolayil, who has been vocal about angel tax for the last two years, sees little improvement in the notification.

“We were hoping that the new notification would bring real changes that address our main concerns but this is old wine in a new bottle. What the new rules have done is replaced one department with another and imposed new restrictive provisions.”

Sreejith Moolayil

Amit Agarwala, co-author, Stones2Milestones which owns Freadom reading app, felt the start-up eco-system has been “given a big boost because of angel investors taking the risk and backing innovative ideas who would not otherwise get funding from banking channels. In such a scenario it is important to distinguish notional income from realised income.”

Industry think tank, iSPIRT, that led the industry petition to PM Modi, felt that while the notification offered “significant clarity” on the application of Section 56 of the I-T Act on start-ups, it needs more changes. Siddharth Pai, founder of 3One4 Capital and Council member of iSPIRT told The Quint

“It’s a definite step in the right direction but needs a few more changes to make this a comprehensive solution that will provide relief to Indian start-ups.”

Siddharth Pai, founder 3One4 Capital

The fact that the CBDT is now bound by a timeframe of 45 days to arrive at a decision, has been lauded by various sections. However, the CBDT’s role in the new process has elicited criticism. Amol Kulkarni, Fellow at CUTS International, a non-profit that focuses on consumer rights policy and advocacy, told The Quint:

“The shift in decision-making is a clear indication that the sole objective of the review is likely to be centred around ‘taxation’, irrespective of other key policy and market considerations. CBDT is notorious for pushing Income Tax officers to enhance tax collections, and there is no reason to believe that a similar practice will not be continued.”

Amol Kulkarni, CUTS Internation

The Devils in the Angel Tax Exemption

A look at the provisions of the notification makes clear that while it may have intentions of making the angel tax exemptions simpler, it places new restrictions on start-ups.

So, what does the notification say?

“The aggregate amount of paid-up share capital and share premium of the start-up after the proposed issue of share, if any, does not exceed ten crore rupees”

This clause has been criticised for imposing an arbitrary glass ceiling on start-ups for eligibility in seeking exemption. Experts have reasoned that the amount of 10 crore, which translates into $1.4 million, would barely qualify as a seed round in the United States or Singapore, but is expected to sustain an Indian start-up till they make an IPO.

“The intention of the clause is sound, but it imposes a glass ceiling upon start-ups in terms of RS 10 crore. Capital is the lifeblood of any company and raising further rounds of funding are important accelerants to growth and business development,” said Siddharth Pai. “Even PM Modi has stated that Indian start-ups need adequate capital to grow, hence restrictions shouldn't be placed on this,” he added.

The investor shall have a “returned income of Rs 50 lakh or more for the financial year preceding the year of investment” and “net worth exceeding Rs 2 crore”

This clause has perhaps elicited the greatest discontent. It has been criticised for restricting the initial growth prospects of a start-up. To be eligible for an exemption on angel tax, the investor must have an annual income of Rs 50 lakh in the previous financial year and a net worth of at least Rs 2 crore.

“What must be understood is that for a lot of start-ups, the first investors are friends and family members. Most of them would not be able to fulfil this criteria,” said Moolayil. “Almost 50 percent of my investors are retired executives who are keen to be a part of the start-up growth story. They are domain experts and can be helpful but will fail this criteria,” he added.

“Instead of fulfilling both criteria of income and net worth, they should follow the global model of fulfilling either criteria and lowering the threshold to Rs 25 lakh of income or a net worth of Rs 1 crore.”

Siddharth Pai

“Provided that in case the approval is requested for shares already issued by the Startup, no application shall be made if assessment order has been passed by assessing officer for the relevant financial year”

This provision has dealt a severe blow to the hundreds of start-ups that have been served a notice by the Income Tax Department. “We who have orders won't be able to take exemption and will have to pay,” said Moolayil.

“Such artificial distinction creates an uneven playing field in the market, and while may partially benefit some deep-pocketed investors and start-ups in future, the fundamental issues with respect to rationale, applicability and impact of this tax on the start-up ecosystem haven’t been considered,” said Kulkarni of CUTS International.

Offering an alternative to the current circular, Siddharth Pai told The Quint that “Any start-up who has received an assessment order should be able to seek recourse under this circular during their appeal.”