In angel tax drama, devil is in the details

A simpler solution would be to just do away with the 'angel tax', no riders attached

Last week, the Central Board of Direct Taxes (CBDT) issued a notification, removing the ill-conceived ‘angel tax’ that was imposed on start-ups more than four years ago. The notification, dated 14 June, amends Section 56(2) (viib) of the Income Tax Act whereby capital raised by start-ups from domestic angel investors will not be taxed as income even if the investment exceeds the fair market value of the start-up’s shares. Earlier, such investments were taxed at the rate of more than 30% as income from other sources.

Massive relief for start-ups? Not quite. The notification also states that the exemption will only be available to those start-ups that fulfil the conditions specified by the Department of Industrial Policy and Promotion (DIPP). In effect, this means that start-ups will first have to get themselves certified as start-ups by the government before they can avail of any tax exemption.

There are three basic norms. One, the start-up should not have been incorporated for more than five years. Two, its turnover should not have exceeded 25 crore in any financial year. Three, it should be building innovative products, processes or services driven by technology or intellectual property.

So far, the start-up certification drive hasn’t progressed very well. Earlier this week, The Economic Times reported that the government’s ambitious Start-up India initiative, which seeks to offer certified start-ups an array of incentives, is up for an overhaul because of poor response. The DIPP, says the report, had received just 200 applications and 30 were shortlisted for consideration last month. Only one, Hyderabad-based Cygni Energy, had made the cut.

By software industry lobby Nasscom’s estimates, India currently has more than 5,000 technology start-ups. Taking into account non-technology start-ups, we are easily talking about a population of more than 10,000 companies.

On Thursday morning, in what looks like a scramble to show results, the DIPP released a list of 88 companies that are now certified as start-ups under the government’s norms. These 88 start-ups will now be eligible for the ‘angel tax’ exemption notified by the CBDT last week.

The government’s inability to get more certified start-ups on board, however, isn’t the big drawback of the ‘angel tax’ exemption. The rider that only such start-ups can avail of the exemption makes it practically useless.

When the previous government introduced the ‘angel tax’ in the 2012 Union budget, it was aimed at curbing the inflow of black money into start-ups under the guise of angel investments. Whether that made any sense in the first place is a discussion for another day.

However, in imposing the tax, the government effectively choked critical capital supply to very young start-ups—angel investors bring in the first capital into a company and usually at the idea stage. Three months after the tax was imposed, following protests from start-ups and investors, the government made a concession. It said that capital raised from notified angel investors would not be taxed as income.

What are notified angel investors? In the 2013 Union budget, the then government provided that capital raised from Sebi-recognized angel funds would not be taxed as income at the hands of the investee company. Such entities are governed by the markets regulator under the norms for Category I AIF venture capital funds.

However, that didn’t really solve the problem. Start-ups raise angel capital from two kinds of investors—organized angel networks such as Indian Angel Network (IAN) and Mumbai Angels and, individual investors. The ticket sizes at this stage can range between 10 lakh and 50 lakh, depending on the kind of business. IAN and its ilk account for less than 10% of the country’s overall angel investments.

Further, in order for start-ups raising money through such networks to avail of the tax exemption, the networks, which currently aggregate individual investors, would first have to convert themselves into funds. To get around the problem, angel networks now increasingly prefer to invest in companies registered overseas.

Individual angel investors fall under two categories—professional angels, usually high net-worth individuals, and family and friends. This is where the ‘angel tax’ hurts the most. The universe of individual angels includes some very powerful professional angels such as Tata Sons chairman emeritus Ratan Tata and Google India chief Rajan Anandan, who could easily channel their investments through Sebi-regulated angel funds.

That they choose not to is a different matter. However, it also includes a host of other individuals who may not have the resources to participate through angel funds—individuals who invest through Sebi-regulated angel funds must invest a minimum of 25 lakh over a three-year period and have net tangible assets of at least 2 crore.

The government could well argue that all these problems would go away if a start-up got itself certified. It’s not that simple. The red tape is an obvious irritant. Making the cut is a bigger concern. Since being an innovative start-up is the primary yardstick for the certification, there’s a big question on how the government would define innovation in the first place. A simpler solution would be to just do away with the ‘angel tax’, no riders attached.

Snigdha Sengupta is a consulting writer with Mint. She contributes stories on venture capital and private equity.

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