Angel tax is an issue that has bothered the Indian start-up ecosystem since it first emerged in 2012. Introduced as a tool to tackle the circulation of black money in the economy, it has been instrumental in sabotaging the Indian startup ecosystem. According to an annual startup-cum-SME survey done by community-based social media platform LocalCircles, 38% start-ups received one or more tax notices in 2018 while 97% clearly mentioned that income tax officers must be educated on startup valuations.
While the Government has attempted to make the measure palatable, it has not really succeeded in clearing the web of confusion despite issuing a series of clarifications.
What Is The Angel Tax Issue?
In 2012, the Finance Ministry introduced angel tax. Start-ups raise funds from angel investors at the early stage. Valuation of early stage start-ups has always been a contentious exercise and angel tax makes it even more so. Suppose a start-up issues 10,000 shares to angel investors, and values each share at Rs. 800, raising a total of Rs. 8 million.
Now, if tax authorities feel that the fair market value of each share should have been just Rs. 200 – in effect, stating that the shares were sold at an inflated rate and the reason for this inflation was to return Rs. 600 per share to the investor in cash, then they can raise a demand for tax at 30% on Rs. 6 million.
The problem with this is that the fair market value is calculated through the discounted cash flow (DCF) method, i.e., taking projected future earnings of the company and converting that into a current valuation. To project future earnings, some data on past earnings is required and so this is usually a great approach for stable companies with a multi-year track record. This approach does not work for start-ups and is not used by investors while evaluating an investment at the early stage.
Relief To Startups
Responding to complaints from the startup community of harassment from tax officials, the Government issued a clarification that liberalized the conditions that a startup must satisfy to claim exemption from angel tax. These included getting registered with the Department for Promotion of Industry and Internal Trade (DPIIT) where the startup is less than 10 years old. The turnover limit has been fixed at Rs. 50 crore and the share premium should not exceed Rs. 25 crore.
The Central Board of Direct Taxes (CBDT) had earlier exempted from angel tax, registered start-ups except those that had received demand notices prior to the change. In a clarification issued on August 10, the CBDT has made the exemption applicable even to those start-ups that have already been issued a demand notice for the share premium.
Impact On M&As
The catch, however remains: Once registered, start-ups cannot invest in any shares or securities, thus practically ruling out all M&As in the start-up space. Registered start-ups are likely to lose immunity from angel tax once they opt for M&As.
Many start-ups from similar industries or sectors prefer to merge to consolidate market share and complement one another’s strength. At times, investors themselves suggest the merger route in order to consolidate their portfolio holdings. However, the angel tax ruling does not recognize any of these scenarios. To be sure, M&As in the start-up space are on a downward spiral.
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As per data from Inc42, the number of startups funded at the seed stage in H12019 was 39% lower than the half-yearly average of 219 from 2014-18. Start-ups funded at seed stage plunged by 40% to 329 in 2018 compared to 546 startups that were funded at seed stage in the pre-angel tax era. There has been a 41% drop in M&As for seed stage start-ups in H12019 compared to H22018.
With fewer seed deals, the potential pool for acquisition is falling every year, especially as startups have not been able to scale or prove their models.
As of September 2018, India has seen the launch of over 49,000 startups – of which 10,000 shut shop with a majority of these shutdowns happening at seed stage itself. From H12017 to H12019, the startup ecosystem experienced a 21% drop in total M&A activity. Acquisition for bootstrapped and seed start-ups fell by 29% and 33% respectively in the same period.
Most prosperous countries globally have grown on the back of entrepreneurship which is an important cog in the engine of economic growth. Chinese unicorns Baidu, Tencent and Alibaba have prospered thanks to preferential tax policies that allow 70 percent of total investment to be deducted from taxation two years after investment in high-tech startups. Similarly, Singapore offers qualifying startups up to Singapore $200,000 tax exemption on their first three consecutive years of assessment. Across the world, nations offer attractive incentives to angel investors and startups to thrive, a stark contrast to the situation in India.
In the long run, thwarting the growth of startups will not only lead to loss of precious jobs but will also have an adverse impact on tax revenues collected.