Repeal angel tax

Rewriting Section 56 (2) to exclude start-ups is difficult

The government is reportedly planning to raise the investment limit for availing income tax concessions by start-ups, and provide a clearer definition. The Department for Promotion of Industry and Internal Trade (DPIIT) has decided to form a working group to resolve the “angel tax” tangle. These are welcome developments as they signal that policymakers are becoming aware of the major issues caused by Section 56(2) of the Income-Tax Act. But while the Central Board of Direct Taxes (CBDT) has decided to go slow on demands under the section, and a mechanism for exemptions has been created, more than 2,000 start-ups have already received income-tax notices. Last week, two start-ups complained that their company accounts were frozen by the tax department and money withdrawn on account of angel tax demands. Though the CBDT later clarified that these were not related to angel tax, the fear factor persisted.

However, a lasting solution to the problem is deleting the contentious clause. Industry stakeholders, tax experts and the DPIIT itself have recommended the clause be scrapped. And, the government’s plan to come up with a definition of a start-up sounds good on paper, but may prove to be a difficult task. The issue with the Section arises from the concept of taxing closely-held, unlisted companies, which issue shares at above “fair value”. The difference between share price and “valuation” is taxed as income. This provision is supposed to prevent money laundering and to detect money being siphoned off into shell companies. Unfortunately, there is no hard and fast rule for valuing start-ups. Valuations are especially difficult in a service-oriented economy where new businesses are asset-light. Angel investors apply a combination of art and science to estimate growth while investing in start-ups. Entrepreneurs and investors accept this equation of high risk and high reward. Repeated tax notices add an unnecessary element of stress to an already high-risk ecosystem. Another troubling oddity is that this Section is discriminatory in that start-ups raising equity abroad are not subject to this scrutiny. Given the framing of the Section and the discretionary powers of officers assessing valuations, notices are more likely than not for Indian-funded start-ups. It is estimated that over 70 per cent of start-ups, with Indian investors, have received IT notices.

The exemption process is cumbersome, involving applications with lots of paperwork to the DPIIT, which has the discretion to recommend exemptions to the CBDT. Rewriting the Section to exclude start-ups from its ambit is easier said than done. How does one define a start-up, and distinguish it from a newly registered shell company? On paper, a newly registered shell company is indistinguishable from a bona fide start-up until it has started generating revenues. There are other tried and tested ways to identify money laundering. Indeed, the government claims that it has deregistered millions of shell companies in the last four years. Money laundering and tax evasion are pernicious practices that need to be eliminated. But the start-up ecosystem is vitally necessary for generating business activity, and for creating employment. The angel tax clause must go if it cannot be rewritten to explicitly exclude start-ups from this form of tax terrorism.