The angel tax has been an albatross around Startup India’s neck since the very beginning. This measure, introduced by the previous government in 2012, was originally conceived as a means of preventing the laundering of black money through unjustified premiums paid to private limited companies. But six years down, it’s come to represent the sweeping powers that tax officials have on startups and their valuations.
Section 56(2)(viib) or the “angel tax” section seeks to tax the difference between the price at which a private limited company raises funds and the Fair Market Value (FMV) of the shares issued. The law allows for 2 valuation methods at the discretion of the assessee company: Book Value and Discounted Cash Flow (DCF) method. Book value represents the net worth of the assets of the company as of today, while DCF takes into consideration future earning and growth potential.
So the latter method is the de-facto choice for any young tech company raising funds since they are asset-light and investors look at future growth, not current assets,The core issue is that the Assessing Officers (AO) are putting themselves in the shoes of the investors and determining the value of these companies without making any investment! These officers are disregarding the valuation report prepared as per the law and are instead using the Book Value of these companies as the Fair Market Value and taxing the difference as income.
No other system seeks to tax a capital receipt and investment as income. Some officers are even comparing the past performance of the company against the projections and taxing the difference! Its bad enough that entrepreneurs face shareholders’ ire when they don’t meet their numbers, but now they need to face the taxman’s brunt as well. This also leads to a vicious loop wherein the company who faces this notice needs to raise funds to pay the notice, which exposes them to another — a vicious cycle.
But the AO has another tool in his arsenal: Section 68 — which deals with unexplained cash credit. To verify the source of funds, the company is asked to get their investors’ IT returns, financials and bank statements to prove creditworthiness. These documents are sensitive in nature and no investor would want to share this with a company in which they are investing. Its no wonder that the number of angel investors in India has dipped 48 per cent from 653 angels in 2016 to 343 in 2018.
This section and 56(2)(viib) is discriminatory and only applies to resident investors — thus its no surprise that 90 per cent of capital coming into the startup ecosystem is from abroad. At this rate, angel investments — the first and riskiest cheque into a startup — will dry up completely and all our startups will be foreign owned.
All capital raises by startups are matters of public record. The government should allow for information sharing between the MCA and CBDT to ensure that these roving inquires are reduced. Innocent companies who follow the letter and spirit of the law shouldn’t be penalised unjustly. Tax officers should also be stopped from abusing discretionary powers by disregarding valid valuation reports arbitrarily and levying obscene demands for 30 per cent of all capital raised.
Chanakya stated that governments should collect taxes like a honeybee, which takes the right amount of honey from the flower so that both can survive. You can’t grab the entire hive and wonder why there isn’t any honey anymore. After all, a tax is not the best form of defence.
(Views expressed are personal)