The unease of starting up

Ease of Doing Business might be dominating the political discourse but there seems to be no end to the hurdles entrepreneurs face. Once such issue that has been dragging for the last five years is that of the angel tax.

Angel tax is making headlines now as the slews of startups are being slapped with notices from income tax department. According to Finance Act if a private company, big or small, receives investment from an outsider who is India resident and the capital raised is more than the 'fair value', then the premium is taxable. Under Section 56(2)(viib) of the I-T Act this amount is considered as 'income from other sources' and is taxed at the colossal 30.9 per cent or even higher up to 34.61 per cent, depending on the amount of income.

Through an amendment in June 2016, Central Board of Direct Taxes (CBDT) issued a notification that the capital raised by startups fulfilling the conditions specified by the department of industrial policy and promotion (DIPP) will not be taxed. However this helped only a few startups that are less than five years of age, not have turnover of more than Rs 25 crore, and are recognized as 'innovative along with several other such norms.
 
The main controversy is in the concept of 'fair value'. Investors value a company based on its potential and future capacity accounting its footprint, GMV, click through ratio, growth rate, revenue run rate etc. However, problem arises when the performance of the company doesn't match its initial projections and the IT department due to the benefit of hindsight invalidates the original valuation, thereby, reducing its 'fair value' at the time of assessment and increasing the premium amount on which the tax is to be levied, says Sunil Shah Partner at Deloitte India.

Startups work on certain presumptions and each valuation is done after rounds of negotiations, valuation reports, bankers report and several other regulatory compliances between the company's promoters and the investors. In fact, there can be circumstances that the company is struggling to stay afloat and its valuation would have decreased anyways. But that doesn't invalidate its original projections. There are several reports that suggest that almost 80% of startups fail within the first five years. Several founders and investors have been questioning the rationale of the IT department on asking startups to pay tax on the amount they raise 2-3 years back irrespective of whether they made profits or not.

Taxing profit on the capital invested by investors, or the profits of the company is fair but taxing the capital raised doesn't seem logical, says Bhairav Kothari founder of SuperCFO. "Whether it is share capital or share premium that is raised by the company, it is still capital received. It should not be treated as revenue income."

He says that the IT department is not just asking for 30.9% tax, but the interest and then also raising demands for penalty for non-payment of tax. "What motivation will an entrepreneur have to start up in India," he asks.

A tax expert who spoke on condition of anonymity says that he believes that the rationale of this law was to address the issue of money laundering wherein people were taking up shares at a premium for very little equity and using this mechanism to convert black money to white. He asks, can all investors be brushed in the same colour due to a handful of black sheep. He suggests, the right way perhaps is to ask if it is a registered Fund in India or if there is a Tax residency certificate or PAN Card number, audit reports, shareholder agreement, share purchase agreement etc before the notice is being issued to companies.

The overarching problem, he says, is caused by the problem in revenue recognition policy of the Income Tax department. He explains that IT officials have targets to meet for the revenue collection, just like sales people in companies. On top of that, if they book the company by sending them a demand notice, the specified amount becomes a part of their revenue and its an easy way to meet their targets. He suggests a better way would be for senior members of the department to lay down detailed parameters for fair assessments, before making such additions to income, and to check the genuiness of the transaction. Only then should the claim in the notices be allowed to be accounted as revenue, and not merely by raising a demand notice. Otherwise we will not only discourage entrepreneurs but will also add on to an already long queue of tax litigations.

Laws such as these especially for fledgling companies will put India on a back foot and kill the motivation in entrepreneurs to startup in the country.