Now Startups Breathe Easier As Government provides Investors relief from Angel Tax

BackGround

Is there now a tax on doing good? Well, if you’re referring to Angel Tax, that’s not what it is. What we discuss today is a change the Government recently proposed in tax rules for investments made by Indian residents in startups, also known as Angel Tax.

What is it?

Closely-held private companies receive equity funds from outsiders. When these investments are made at a premium to the fair price, tax laws have so far held that the amount raised in excess to the fair value is taxable. The amount is reckoned as “income from other sources” and taxed under Section 56 (ii) of the Income Tax Act. The rate of tax was a hefty 30.9 per cent. This was applied not just to mature private companies, but also to small startups that took early-stage investments from residents in India.

As startups have very few sources of mainstream funding, investors and startups lobbied for the tax to be removed. Already, funds sourced from non-residents and venture capital funds were exempt from this tax. Now, the Centre has moved to exempt investments made by Indian residents in companies certified as ‘innovative’ startups, from Angel Tax. To qualify, the venture must fulfil certain criteria on age (not more than five years old), turnover (not exceeding ₹25 crore), purpose (building new product or services), and method (technology or intellectual property). It must also be officially recognised as an ‘innovative’ startup by the Inter-ministerial Board of Certification.

Government to make changes in section 56(2) of Income Tax Act in a bid to promote startups.

The government has removed the socalled ‘angel tax’ for investors providing funding to startups under its ambitious plan to boost entrepreneurship and job creation in the  country.

Funding to startups, notified under the government approved plan announced by
PM Narendra Modi in January, will not face tax even if it exceeds the face value.
Resident angel investors, domestic family offices or domestic funds which were not
registered as venture capital funds can now heave a sigh of relief and not worry about the invested amount getting taxed. Under existing rules, funds raised by an unlisted company through equity issuance are covered under this tax to the extent the amount is in excess of the fair market value.

Such extra inflow is taxable as “income from other sources” under Section 56(2) of the
IncomeTax Act and charged the corporate tax rate, resulting in an effective tax of over
30%. The venture capital industry has been lobbying for removal of this tax, terming it a
big deterrent to investments.

In many cases, the valuation of startups is far in excess of market value as it is based on
the promise of the idea and not the immediate worth. In such a case, the startup would
end up losing a chunk of the inflow to this ‘angel tax’. The Central Board of Direct Taxes
has issued a notification to this effect, exempting startups raising investments from the
rigours of Section 56(2)(viib).

Earlier in June month, the Central Board of Direct Taxes (CBDT) issued a notification, repealing the much talked about angel tax in a bid to boost entrepreneurship in the country. However according to investors, the move has serious limitations and will only help a few start-ups owing to multiple riders associated with the definition of a start-up.

In a notification on June 14, the CBDT announced an amendment to Section 56(2) (viib) of the Income Tax Act. Under this, money raised by start-ups from domestic angel investors will not be taxed as income even if the investment exceeds the fair market value of the start-up’s shares. So far, the so-called extra inflow was taxable as income from other sources under Section 56(2) of the Income-Tax Act. It was charged the corporate tax rate which resulted in a tax of over 30%.

According to the government, an entity will be considered a start-up till five years from the date of its incorporation and if its turnover for any financial year has not exceeded Rs25 crore.

It is also supposed to be working towards “innovation”, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property.

In order to obtain the tax benefit, a start-up needs to get itself registered with the Department of Industrial Policy and Promotion (DIPP).

The catch is that out of multiple start-ups that will apply for this certification, not all will be eligible for that.

“The presumption is not everybody will get a certificate … The number of start-ups that have applied is far higher than what has been approved and that just tells you that there are many who will be just left out of the certification process for various reasons,” said Padmaja Ruparel, president at Indian Angel Network.

Ruparel also said that defining criteria such as “innovative” is subjective. “What is innovation? Those who are not “innovative” they will flip out of the certification process. There will be many who will not get covered. They will continue to be subject to section 56,” she said.

Sunil Goyal, founder and chief executive officer of YourNest Angel Fund termed the move as merely an incremental step. “The start-up needs to be registered and the process of that particular application, the criteria and the approval process is all very tedious,” he said.

Why is it important?

Section 56 of the Income Tax Act confers on tax authorities the power to levy excess consideration, more than the fair value, against issue of shares. Section 56 (2) (vii) (b) of the Income Tax Act states:

“Any consideration received by a company (startup) from a resident, against issue of shares, exceeds the fair market value of such shares, such excess consideration is taxable in the hands of the startup, as an income.”

Such extra inflow is taxable as “income from other sources”and charged the corporate tax rate, resulting in an effective tax of over 30%.Additionally, this section exempts venture capital funds registered with Securities and Exchange Bureau of India (SEBI). Hence, it affects only those startups that are funded by angels or funds not registered with SEBI. Consequently, as most of the rounds in these startups are made by angel investors on the  basis of faith and confidence in the team with little eye on valuations, the venture capital industry has been lobbying for removal of this tax, terming it a big deterrent to investments.

Angel Tax was, therefore, problematic for a few reasons. For one, valuing startups based on their assets alone, given intangibles such as goodwill is not easy. Nor is it easy to arrive at a ‘fair value’ for them, based on discounted cash flows. So, startups are often valued subjectively and the valuation which seems sky-high to some, may be fair to others.

Two, higher valuations when raising funds, are beneficial to founders as it means giving up less equity. But given the closed nature of these deals, there were concerns on whether there was creative financial planning happening. The tax was introduced as an anti-abuse provision in the 2012 Budget to curb attempts to launder undisclosed income. Now, the relaxation could signal the willingness to nurture innovative firms.

Three, as opposed to the idea of taxing angel investors, investors in countries such as US are actually offered tax benefits when they fund small companies. There are also ways for angel investors to save tax by re-investing gains from one small business into another venture. But in India, there was an element of suspicion over startup investments. Attempts to simplify the tax treatment are hence welcome.

Why should I care?

For startup founders, venture capital firms and overseas investors are the key sources of funds and angels typically make up a small portion of the capital. But who knows? The removal of the tax may encourage more participation by local investors and help a newbie entrepreneur make a pitch to thecrorepati next door.

If you are a resident investor and wealthy enough to play angel, you still need to note that only certified startups are exempt from Angel Taxes. So far, given that the scheme to certify startups is yet to flag off, no startup has a readymade certificate. Experts expect only a few startups to file and given the requirements only 1-2 per cent may pass the test.

Conclusion : The bottomline

The change, while good, may help only a few startups take wing.

 

VidyaSunil & Associates is into practice of Tax Complaince, Audit, Accounts , Corporate / Business Finance & Outsourced CFO Services.

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