Drop the angel tax: Stop taxing startup investments as income

Early-stage losses are the norm for startups, not an exception. (Mint)
Early-stage losses are the norm for startups, not an exception. (Mint)

Summary

  • The premise of this tax is dubious, its application has had a harsh impact, as investment trends show, and India should relieve startups of this absurdity without ado.

Much has been written about India’s ‘angel tax,’ an innocuous coinage with diabolical consequences. It’s in the news again, as the department for promotion of industry and internal trade (DPIIT) is reportedly in favour of startups being relieved of it. 

It’s a uniquely Indian innovation that converts capital into taxable income. It’s a tax on capital in a country short of capital, and thus antithetical to the government’s agenda of attracting capital to India. It often seems like a cruel joke.

Also read: Mint Quick Edit | Go ahead and axe the angel tax

Its origin: Section 56(2)(viib) was inserted in 2012 by then finance minister Pranab Mukherjee under a series of measures titled “Measures to prevent generation and circulation of unaccounted money". It applies to unlisted companies that issue securities at a premium to investors, when the price at which these are issued is higher than their “fair market value." The difference is subject to tax in the hands of the issuing company.

Since 2016, this section has been applied to startups that raise capital from investors for nascent business ideas. As the money raised is from ‘angel investors’ (primarily high net-worth individuals and family offices), it was dubbed an ‘angel tax.’ It originally applied only to investments from Indian residents, but was extended to non-residents (with carve-outs) from 2023-24 onwards.

Also read: Budget 2024: DPIIT recommends removal of Angel Tax

Its flawed assumptions: The notion that a high share premium is a sign of unaccounted-for funds mistakes correlation for causation. A high share premium is an outcome of legitimate business decisions taken by a company. For example, the number of securities issued in the past could be low, with their face value low too, while the current valuation of the business could be much higher. Each is permissible under Indian law.

A company with 1 lakh of paid-up capital at 1 per share, with an average pre-money valuation of 10 crore now would result in an issue price of 1,000 per share, or a premium of 999. But this would likely result in angel-tax notice from authorities.

The tax department uses a system known as Computer-Aided Selection of Cases For Scrutiny (CASS). As the department states: “CASS is a system-based method for scrutiny selection which identifies cases through data-analytics and three-hundred sixty-degree data profiling of taxpayers and in a non-discretionary manner."

An analysis of various companies that received such notices would suggest that the criteria employed for angel tax include the question of whether a loss-making business issued shares at a premium.

Early-stage losses are the norm for startups, not an exception. They invest heavily in teams, their product-market fit, marketing, etc, in the early years, faced as they are by intense competition, often from entrenched players.

Getting a business started incurs high costs much in advance of revenues, with the expectation that these will rise and costs will stabilize or flatten over time. Such losses do not indicate lack of value creation, as they are investments in a revenue ramp-up over time.

Also read: What is Angel Tax and why is it a concern for the Indian startup community?

Its core issue: The practice of assessing officers comparing startup projections in its valuation report with actual performance, with no regard for a valuation report in case of deviations, is problematic. As forecasts, projections are subject to execution risk. Even India’s budget sees adjustments. New businesses operate under more uncertainty, and the equity risk taken by investors covers it.

While combating unaccounted funds is a global issue, no other country has taken the approach of taxing a share premium as income. The US Internal Revenue Code, for example, categorically states that the exchange of stock for cash/other consideration shall not be treated as income.

Its patchwork fixes are not a cure: Angel tax notices began to pick up in 2016. On 19 February 2019, the department for promotion of industry and internal trade (DPIIT) provided relief from this tax with conditions. A DPIIT startup was exempt from angel tax for 25 crore worth of shares issued at a premium, provided the funds were not invested in a blacklist.

Many conditions were reasonable and had a carve-out for transactions undertaken in the ordinary course of business, but three bars crippled this concession: on giving loans and advances, capital contributions to other entities and investments in shares and securities. This effectively bars salary and vendor advances, rental deposits, investment of surplus funds in treasury instruments, investments in subsidiaries or joint ventures, and the creation of a trust for employee stock options.

It applies for seven years after the fund-raise. As a firm may remain a DPIIT startup for 10 years, the bar on routine transactions can be for 17 years. Many startups have surrendered the 2019 exemption because of these conditions.

In 2023-24, Section 56(2)(viib) was extended to non-residents as well (with carve-outs). Five additional valuation methods, leeway of 10% issue price variance from ‘fair market value,’ a list of safe-harbour countries, etc, have failed to mitigate this blow. The Indian startup ecosystem raises around 85% of its capital from overseas.

Of the top five countries of origin, three—Singapore, Mauritius and the Netherlands—are not part of the 21 safe harbours. Since the tax was extended to non-residents, startup funding dipped by an estimated 63% in 2023-24, year-on-year, with the lowest amount raised in six years.

Since 2012, various measures have been taken to combat unaccounted funds. Unlisted company shares were made to go demat, all issuances had to be reported, unlisted securities had to be disclosed in Income Tax Returns, and more, aimed at transparency. Listed companies are excluded from the scope of Section 56(2)(viib) as they meet various transparency norms.

Also read: How angel tax provisions will attract global investments?

Unlisted companies should also be excluded for similar reasons. There already exist sufficient tools for the tax department to nab bad actors. Such an exclusion will stop genuine startups from being harassed and driven out.

The Congress Party, which introduced this angel tax in 2012, stated in its manifesto that it would remove it. The ruling BJP stated in its manifesto that it would “completely revamp our economic and commercial legislations to suit our economic needs."

Lifting this burdensome tax on investments should be the first step. It will not compromise India’s fight against unaccounted funds. Startup India has been crippled by the angel tax. Stop-gap relief has not solved the problem. The removal of Section 56(2)(viib), however, can reverse India’s dip in startup funding and give entrepreneurs and investors the confidence they need to invest in India and generate success stories.

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