Angel Tax, which is the tax on capital raised by unlisted companies by issuing shares in excess of their “fair market value”, continues to be a bone of contention for startups more than 18 months after the government exempted “innovative startups” from this tax.

However, startups and lobbyists are hopeful that the government will resolve this issue during the upcoming Union Budget or earlier, since industry estimates indicate that angel tax is one of the main causes for the fall in early stage funding in the country, which has been declining every quarter this year. “We are in internal discussions on the matter,” a government official said to The Economic Times. “However, nothing is expected to come out anytime soon.”

As per Section (56)(2)(vii)(b) of the Income Tax Act, if a company receives any consideration from a resident for issue of shares exceeding the face value of such shares, then the aggregate consideration exceeding the fair market value of the shares will be taxed as ‘income from other sources’. Currently, the angel tax is 30%. On June 14, 2016, the Government had announced that ‘innovative startups’ will be exempted from the aforementioned tax. However, this applies only to those ‘innovative startups’ which have been certified by the Department of Industrial Policy and Promotion (DIPP) and comes with a number of riders.

“This was for only 2016. Therefore companies that raised monies prior to 2016, when the Act changed, and up to 2016, when they registered, continue to be harassed by the I-T officials,” TV Mohandas Pai, one of the country’s most active early stage investors said.

Presently, the angel tax is applicable to individual investors, while venture funds are being exempted from it. However, angel investors are not being recognised as venture capital funds. Experts have stated for long that the angel tax is the major reason for the fall in angel investments in the country. According to a member of a prominent angel group, the issue can derail India’s startup funding story, one that according to them, “hasn’t even begun yet”. The angel groups have meanwhile stated that they should be permitted to register as legal entities, so that investments can be made freely and therefore the trend of declining angel investments can be reversed.

“Since there are concerns that investments in startps may not be necessarily made by genuine investors , there has to be a way angel groups and genuine high net worth individuals can be recognised just as venture capital funds in the country are recognised as legal entities,” said KS Viswanathan, Vice President (industry initiative), Nasscom said.

The main cause of concern for India’s startup entrepreneurs and the angel investors is the issue regarding the calculation of a start-up’s fair market value. Currently, the fair value of a startup is evaluated by the income tax officials at their discretion, which happens to be completely arbitrary in nature. “We protested on this particular issue,” TV Mohandas Pai said. “In India, the methods of assessment are completely broken. It is much better that we ask the government to not do these perverse assessments, and that’s why it’s become such a big issue right now,” he added.

A number of angel networks have also pointed out that it is not their duty to differentiate between legitimate and illegitimate investors and startups, rather that is something the government’s responsibility.

“We are actively lobbying the recognition of angel networks, not just the large ones but the smaller ones as well because we are still a very early–stage ecosystem and we don’t want a situation wherein newer networks don’t come up across different regions in the country due to regulatory blockages,” said Nandini Mansinghka, Chairperson at Mumbai Angels (an angel investment network) was quoted saying.

Furthermore, there is the added regulation that opening up of a deal to more than 200 members/ parties, will imply that it is a public issue and not a private deal, as per the Companies Act. “That is a setback for very early stage startups since they are risky investments and need exposure to more members to invite interest,” Nandini said.

In conclusion, regulations are posing several constraints to the functioning of angel networks, especially regarding differences in the valuation of startups by the networks and those arrived at by the income tax authorities.

(Picture courtesy: assets.entrepreneur.com)