Angel Tax: Killing The Goose That Can Lay Golden Eggs

Angel Tax is about start-ups that do not raise millions of dollars every year and grab headlines in pink newspapers. It is about start ups about whom the Prime Minister and the entire country is passionate about and is ready to figuratively bet their last rupee as the great deliverer of India's impending unemployment problem. However, from the numerous complaints I have personally received about the way Angel Tax is assessed and charged, it seems that the Central Board of Direct Taxes is reading out a different script on start ups - one which is daimetrically opposite to the rest of the country.

Coming to facts. Here are some of letters of complaint that I have received. Netgear, recently raised INR 1.8Cr from angels and were asked to pay INR 57.2 lakhs as taxes because the authorities claimed the entire investment was premium over fair market value (FMV) of INR 1.  Bite Club was asked to pay taxes of INR 60 lakhs on an investment of INR 1.5 Cr as the authorities concluded the fund raise was a premium over FMV of INR 0 ! KarmYog Education Network received IT Notice of INR 2.5Cr despite providing all the clarifications, valuation reports and is absolutely in no position to pay. True Elements received IT Notice of INR 40 lakhs was compelled to pay INR 8 lakhs.; Posists received IT notice of INR 12 lakhs and was forced to pay INR 2.4 lakhs.

In the last couple of years, start up investments have been more due to exits of large venture funds and entry of other large ones from well-known start ups, or in the form of strategic investments in mature start ups. Angel funding which waters the roots of the start up ecosystem seems to be gradully drying up or moving overseas.

The root of the problem lies in the Finance Act 2012 that introduced new provisions for Income tax on premum paid for subscriptions to shares of a company, to the extent such shares' premium is in excess of the FMV. Share premium paid by investors for subscribing to shares in a private company is taxable in the hands of the company at 30% (exclusive of surcharge and cess) if and to the extent it is more than the FMV.

The bone of contention is calculating the FMV of a tech start-up; and more specifically the methodology for doing so. Valuation is based on valuation certificate by a valuer recognized by the government. Valuers in India look at traditional methods of valuation which apply to mature companies with regular cash flows.
Most technology start ups raise money before monetization and there is no underlying actual cash flow analysis available for traditional valuation methods. Most startups are almost always asset light and do not have assets in their books to justify their intrinsic value.

Tax authorities refuse to accept Discounted Free Cash Flow (DCF) Method for calculating valuation of start-ups, even as that is most common process of valuation and is recognised under Rule UA(2) as one of the 2 methods of valuation for unquoted equity shares. They claim this is done at the behest of the management. In many cases, when start-ups are unable to achieve the projections as per DCF valuation, the authorities argue the valuation must be revised on a backdated basis.
Conventional valuation methods fail to take into acount the uncertainities surrounding a start-up. Valuators can at best validate the basic assumptions, market potential and other macro-factors, but it is not possible for a anyone to have perfect foresight of what will happen in the future. There are too many risk factors that can lead to failure to achieve projections and more than 90% of the startups statistically fail to do so.

Ironically, the actual provisions recognised this problem and thus has exception clauses for start-ups to promote entrepreneurship. However, the eligible criterion for start-up has numerous criteria like maximum turnover of INR 25 Crores, maximum 5 years of existence, nature of business. A critical criterion is certification of elligible start-ups by the Inter-Ministerial Board of Certification.

While the intent behind the new provisions to curb generation and use of unaccounted money is well accepted, the exceptions granted cover only a limited range of circumstances and genuine commercial business decisions also get affected. The fact that since 2016 only 74 start-ups have been certified 'eligible' by the Inter-Ministerial board highlights the ineffectivness of the exception provisions.

The authorities deem all start-ups 'guilty till proven innocent'; as even the appeal process requires them to deposit 20% of total tax claimed and file for appeal within 30 days of receiving a notice! For many cash strapped start-ups, complying to such draconian regulations is virtually impossible.
Both founders and investors are extremely wary of this provision and many companies are actively seeking to relocate to more start up friendly jurisdictions overseas.

The digital industry is not averse to paying direct taxes, but such taxation should be on actual profits and not notional ones. Given the high rate of failure of start-ups, this is a critical aspect of taxing the fast evolving tech sector; or we run the risk of killing the goose even before it lays a golden egg!