Where angel investors fear to tread: The law that's taxing Indian start-ups

Despite relaxations and guidelines announced by DIPP and CBDT over the last couple of years, valuation mismatch continues to divide tax authorities, investors and the start-up community

Angel investors and start-ups have been crying foul, time and again, over the issue of angel tax. Over the years, the government’s stance on this issue has undergone several changes since its introduction to the statute books following the 2012 Budget speech by the then finance minister, Pranab Mukherjee. Sections 56(2)(viib) and 68 of the Income Tax Act 1961 — that form the crux of angel tax — were enacted into law as a means to plug the laundering of black money through unlisted entities.

Despite relaxations and guidelines announced by the Department of Industrial Policy and Promotion (DIPP) and the Central Board of Direct Taxes (CBDT) over the last couple of years, valuation mismatch continues to divide tax authorities, investors and the start-up community. “The problem crops up because the valuation of a start-up firm is highly dynamic and often subjective based on the discounted cash flows, and it may undergo a major change over a short span,” says Vikas Vasal, national leader — tax, Grant Thornton India. This leaves most start-ups vulnerable to scrutiny by the taxman. “Tax authorities feel the investment being brought in is too high vis-à-vis their valuation,” adds Vasal.

Experts point out that the current law does not provide for any respite to this issue and only an administrative safeguard can be ‘promised’ or provided to a start-up and its investors, pending amendment to law. “An amendment to put to rest this issue is highly probable in the upcoming budget,” says Pranay Bhatia, partner,  Tax & Regulatory Services, BDO India.

According to Siddarth Pai, founding partner, 3one4Capital, Section 56(2)(viib) of the Income-Tax Act should be done away with since it gives the assessing officer significant discretionary powers over these start-ups. “Valid valuation reports should be accepted unless the assessing officer can prove that the funds were syphoned off or laundered,” he adds.

Ajay Rotti, partner, Dhruva Advisors, is of the view that the field officers could be instructed to record reasons to establish reasonable doubt for a case of tax evasion before invoking these provisions. “With further strengthening of the anti-money laundering and benami transactions laws, officers should not be permitted to invoke Section 56(2)(viib) in all cases,” he adds. 

What start-ups, investors face
 

• Section 56(2)(viib) and Section 68 of the I-T Act give the assessing officer significant discretionary power over start-ups to conduct roving investigations
• Disallowance of the valuation report by the assessing officer; disregarding the choice of valuation method 
• Onus on the start-up to offer proof of the source of funds
• Domestic investors say these provisions put them at a disadvantage against foreigners

What industry wants

• Link the Ministry of Corporate Affairs (MCA) and CBDT databases
• Modify the tax return form of companies to include the DIPP registration number, details of the capital raised
• Introduce the accredited investor concept to include a schedule for such investments
• Modify Section 68 to allow the assessing officer to seek any additional information on the source of funds from investor
• A declaration by the start-up that the capital raised has not been re-invested into the investor’s business or any related party

(Source: White paper by iSpirt)

A way forward, say experts, could be to linking the MCA and CBDT databases, so that the Start-up India registration and the capital raise information filed with the MCA can be accessed by the tax department. “This will go a long way in reducing the paperwork required and interactions with various government officers,” says Pai.

Further, the tax department could make the PAN submission by an investor in a start-up mandatory. This will enable the tax department to match the investment amount against the returns of the investors.

Currently, the law makes it mandatory on start-ups to seek such information from their investors. “No investor likes to hand over his/her tax returns, bank statements or financials to the investee company to prove creditworthiness,” says Pai.

Many tax experts point out that Section 56(2)(viib) of the I-T Act is unique as it taxes capital receipts as revenue. “This artefact goes against the government's stated mission of promoting entrepreneurship and start-ups. While other countries like the UK and Singapore promote angel investing through tax breaks and credits, India is taxing such investments,” says Pai. 

Many in the start-up and investor community feel Section 56(2) (viib) places domestic investors at a disadvantage since it seeks to tax their investments into private companies as revenue, whereas foreign investors are excluded from the same. 

According to Pai, as a result, there has been a 48 per cent dip in the number of angel investors in India — from 653 in 2015 to 343 in 2018. “India needs to promote domestic capital participation in start-ups otherwise we run the risk of our best companies being majorly owned by foreigners.”

Many in the investor community feel Section 68 of the Income Tax Act — which seeks to tax unexplained cash credits — is actually the devil in the angel tax imbroglio. 

The ball again is in the government’s court to set the record straight.