Review angel tax

Start-ups and investors need more than easing of norms

The new notification easing norms for exemption from the so-called angel tax under Section 56 (2) (viiib) of the Income-Tax Act with retrospective effect from April 2016 will afford some relief to many start-ups and investors. It is encouraging to see that the government has taken note of the many objections raised. The Central Board of Direct Taxes (CBDT) is mandated to evaluate and respond to each application within 45 days. This is a welcome development, though some key issues still remain. The law itself is inconsistent with the realities of start-up investing. Though some norms have been eased, the procedure to apply for exemption still remains cumbersome, and government officials retain a great deal of discretion in either clearing exemption or raising tax demands. Moreover, the exemption limit is low, since it applies to start-ups under Rs 10 crore. The definition of an investor remains rigid and the new clarifications also appear silent on the recently mooted concept of an expert committee, which could study eligibility criteria for exemption.

 
The essential problem with the angel tax is that it revolves around the “fair value” of a new business. The tax demand could be levied if an assessing officer believes that the equity of a new business has changed hands at above “fair value”. Unfortunately, almost by definition, fair value is impossible to ascertain for an unlisted new business. A new business has no track record and it may be light on assets as well, especially if it is in the services sector. Investors will back a new venture after valuing it in terms of what they think of the growth prospects. It is impossible to judge, except with the benefit of hindsight, whether any given valuation is fair or not. The new procedure to seek exemption involves an application made by the start-up to the CBDT, via the Department of Industrial Policy & Promotion (DIPP). The DIPP, therefore, has the discretion to recommend an exemption. The process of application has been streamlined but an unrealistic amount of personal information must still be provided. The investors must be accredited and they must share their source of funds with the start-up seeking an exemption. Most investors would be wary about sharing such information. Hence, this is a stumbling block that could mean few applications for exemption. An investor is defined in the new notification as somebody with a minimum net worth of Rs 2 crore and this investor must have submitted an income tax return of at least Rs 50 lakh at least once.

 
So the essential problem — the unclear definition of fair value — remains. Start-ups and angel investors will continue to struggle when it comes to explaining how they have valued a given business. The law was created in order to prevent money laundering through the medium of a shell company floated as a start-up. This is an understandable objective. But the concept of “fair value” is not a suitable way to judge if money laundering is occurring. Nor is it fair to burden a legitimate business with the task of ascertaining where investors source funds. The vast majority of start-ups are legitimate. The particular Section of the I-T Act, introduced in 2012, taxes any investment made by an Indian entity in an unlisted Indian company above fair market value as income. As long as it remains, it will continue to scare away legitimate entrepreneurs and investors. It’s time to review it.