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Angel tax is an income tax levied by the government on start-ups, for the funding it receives from ‘angel’ investors in return for the sale of its share capital. These investors are generally high net worth individuals, who inject capital in start-ups in return for ownership equity and convertible debts. They, rather than investing individual investors’ money (like a venture capitalist), invest from their personal wealth. They may not necessarily operate on a profit motive and generally provide favourable terms to the company.
Angel tax derives legal validity from Section 56(2)(viiib) of the Income Tax Act, 1960. S. 56(2) lays down the incomes that shall be chargeable to income tax under ‘income from other sources’. Sub-section (viib) lays down that if a company in which the public is not “substantially interested” receives consideration for shares, the amount in excess of fair market value would be taxed. Therefore, in India, the entire amount of investment by an angel investor is not taxed. Additionally, the SEBI (Alternative Investment Funds) Regulation, 2012 recognises ‘angel funds’ as those raised by unlisted companies from investors. The Commerce Ministry has, by a notification released in February 2019, fixed the threshold of paid-up share capital of Rs. 25 crores, below which a company would qualify to be exempt from the levy of angel tax.
What started initially as a stringent tax has seen developments throughout the years that have resulted in an increase in exemptions that may be availed of. However, start-ups in India have protested against the imposition of this tax, including an online petition in 2018. Needless to say, angel tax is limiting crucial funding for start-ups as a significant portion is being taxed, especially due to its continued strict imposition.
This article argues that the current imposition of angel tax may not be producing favourable outcomes for young start-ups and to that extent suggests certain recommendations.
An Analysis of India’s Angel Tax Regime
The current government of India has had a very firm policy against black money. For example, the demonetisation carried out in 2016 was done with the motive of countering the same. The primary objective of the government in introducing angel tax was to curb money laundering and reduce black money in circulation. The mechanism was simple. The purported money launderers would invest their unaccounted money in the assets, valued at a higher rate, of the company of their choice, thus laundering the money from black to white. It is also possible that the company is merely a front. In order to disincentivize such activities, the amount invested in excess of the fair valuation is taxed.
The imposition of angel tax, however, is counterproductive because it disrupts the ability to obtain funding for start-ups. It, therefore, does not seem to be in line with the promotion of ‘start-up culture’ policy in India, reflected by government schemes such as Start-up India. Such companies generally do not have a large source of funding. Thus the ‘angels’, who invest large sums into start-ups, are crucial. Their sole aim may not be to seek profits and might even invest because they believe strongly in the idea. However, if a large amount of angel tax – 30.9% in India – is imposed then, naturally, this would deter the investors. Close to 1/3rd of the investment is going for naught and this would have a direct effect on operations. It must be said that the government has done well to understand this and has introduced several exemptions for start-ups, in order to provide a push to their operations. However, these might not be adequate.
Another policy objective that the angel tax is in conflict with is the “Ease of Doing Business” in India. According to the World Bank’s Doing Business Report, 2020, India’s ranking is 63. However, in the category of ‘Starting a Business’, India still remains at 136. This proves that despite successful efforts to ease the overall business environment, starting a business still remains a problem area for the Indian economy. The imposition of angel tax is a direct hindrance, especially for new start-ups that might not have the requisite standing with banks to obtain loans. Aside from the current government’s active policy to improve the ease of doing business, this is a pivotal factor in any given economy. Even in the absence of an explicit policy on the same, it must be the government’s prerogative to ensure that all obstacles in starting and continuing business, especially small and medium-sized ones, must be removed.
The imposition of angel tax is making funding by angel investors extremely complicated. Several conditions need to be met, both by the investors and the company and only then can angel funding be given. The focus of the angel investor then shifts from believing in the idea with which the start-up was built to the compliance of regulatory mechanisms by these start-ups. For example, an investor has Rs. 100 crore he would like to invest. There may be two companies A and B. According to the investor, A has a better and more efficient business idea and he is convinced that these innovations would be fruitful. However, A is unable to meet the regulatory requirements of the government, but B does. In other words, B would be subject to a greater tax exemption. The investor would then be motivated to invest in B and not A, as a lesser amount of his seed money would be taxed, although he might have greater faith in A’s idea, and which might have been more profitable for the economy as well.
As a result of the government’s policies, Indian start-ups are opting to incorporate in countries that have a more relaxed tax regime. Some examples may be China, Singapore and Germany. While Singapore and Germany have offered several tax incentives to start-ups, China allows 70% of total investment in a ‘high-tech’ start-up to be deducted from its taxes. This reflects the liberal regime in these countries relating to start-ups, in order to promote them.
As mentioned previously, the government has, over time, recognised the needs of the entrepreneurs, introduced exemptions for start-ups and taken steps to boost the ease of doing business. The reforms have eased the angel tax regime and made it more conducive. In the budget of 2019, the government announced several measures, including that upon the provision of requisite documents to the DIPP as well as information on income returns, investors and subsequently the start-ups, would be exempt from paying angel tax.
While these measures are welcome, the fact is that angel tax continues to be imposed. The methods to avail the above exemptions are a major administrative hassle for the start-ups and might be virtually impossible for many. A lot of time and resources are diverted into preparing and then filing these documents; time and resources that could be better used in innovation and development, to their full potential. Therefore, overall, the angel tax has been detrimental to India’s start-up culture.
Recommendations and Conclusion
In order for the hassle-free operation of start-ups, funding from accredited investors is essential. Therefore, imposing angel tax ought to be done away with. In order to curb the circulation of black money (a problem that is systemic in India as opposed to the other countries mentioned, such as Germany), the source of the amount procured by the investor ought to be stated and verified and a paper trail for the amount must be clearly established. Further, large transactions in cash must be disallowed and all investments must be made via the banking system so as to trace the funds and increase accountability.
In the interim, if the current regime continues to exist, the government ought to take active steps to ensure that the start-ups gain the full benefit of the exemptions. In other words, the steps taken by the government must be implemented diligently. Further, the Department of Industrial Policy and Promotion [“DIPP”] must not stringently impose procedural requirements and must not disallow exemption on grounds such as faulty paperwork. It must be made a policy to always give the benefit of doubt to the start-ups. After making requisite inquiries as to the legitimacy of their claims, the start-up may be allowed to re-file the paperwork at a later date, without affecting the eligibility for exemption. It must be noted that the DIPP has attempted to ease operational difficulties faced by start-ups and have given them opportunities to voice concerns, given that they are the prime stakeholders.
The angel tax regime is far from perfect. The government has a duty now to ensure that in its attempt at curbing money laundering, it does not crush the entrepreneurial dream that is so essential in fuelling start-ups in India. In an ideal situation, the angel tax ought to be scrapped, however, even if this does not take place, at the very least, the authorities should endure to give all benefits to entrepreneurs and make the system as lenient as possible.
ABOUT THE AUTHOR
Isha Sen is a fourth-year law student at National Law University, Jodhpur.
In Content Picture credit: The Financial Express