Start-ups hope for a reprieve from angel tax

Angel investors — spooked by the angel tax, Sebi’s lens on fundraising by networks, and long-term capital gains on unlisted securities — are hoping for some reprieve in the Budget 2018. Angel investment fell 50 per cent in volume in 2017 and 33 per cent in deal value, according to disclosed deals.

Of course, lack of exits and fatigue also hurt deals. ‘‘The angel tax was a big deterrent. It requires investors to write bigger cheques; 30 per cent more than needed,” says Subramanian Krishnan, partner, private equity & financial services, EY.

Consider the angel tax. When start-ups raise money from angel investors, the founders don’t want to dilute much. Hence, most start-ups issue shares at a premium.

As per Section 56 (II) of the Income Tax Act, a firm issuing shares at a premium needs to justify the premium to the fair market value (FMV).

If they fail to do so, the difference in valuation is treated as income and a start-up is liable to pay tax on the same. Many start-ups have received notices from the income-tax department on this. ‘‘You invest in a start-up at a premium and never at par,” says a Mumbai-based angel investor.

Traditional companies are valued using the discounted cash flow (DCF) method. Start-ups raising money from angels often do so based on an idea and its potential. They have no revenues and, are valued differently. If valuation based on DCF is X and the start-up has raised money at 2X, start-ups have to pay tax on the difference.

‘‘Valuations are always debatable. The same company could be valued X in India, 2X in Singapore and 3X in the US. While VC funds have been exempted from the provisions of Section 56, angel investors have not been. This has hurt the sentiment and impacted investment by larger networks,” added the angel investor, who didn’t wish to be identified.

In 2015, amid growing protests from start-ups and investors, the Centre proposed an amendment to exempt angel tax on investments not exceeding $1.56 million (~1.0 billion).

In 2016, the Central Board of Direct Taxes issued circulars to exempt start-ups from angel taxes even if the funding raised by a start-up exceeded the FMV.

To avail the same, a startup needs to fulfil the government’s definition of a start-up: it should be less than seven years old, have a turnover of less than ~2.5 billion, and, more importantly, it should be registered with the government as a start-up. Till January 31, 2017, 6,767 startups have registered. There are many who don’t fit the criteria.

Introduced by former finance minister Pranab Mukherjee under the Finance Act 2012, angel tax is applicable on the capital raised by unlisted companies from any individual against an issue of shares in excess of the fair market value. The tax has been classified as ‘income from other sources’ under Section 56 (II) of the Income Tax Act of India.

The provision was introduced to check money laundering whereby shell companies issued shares to investors at a huge premium. Start-ups say I-T department is assuming that every start-up that has come under the scanner has been involved in money laundering.

The second issue bothering angels is Sebi’s lens on networks. Sebi has written to angel networks, seeking details on how they raise money and if they operate within the contours of the securities market law.

Angel networks are a key link between start-ups looking to raise money and investors. The capital markets regulator fears that these platforms are acting like stock exchanges and might be violating the rules of private placement by offering shares to more than 200 investors.

Sebi is concerned about how these issues are being marketed. Typically, a private placement is made to a defined set of investors. But the way these deals are sold, the process looks like a public issue. The issue is offered to more than 200 investors on some platforms, even if only 50 investors eventually invest. Many networks have hundreds of angels.

Sebi wants to know if these networks are acting as a pooling vehicle. ‘‘If networks are in compliance, life goes on. If there are exceptions, it could lead to regulations on crowd-funding,” says an angel investor.

If a start-up needs to pitch to 1,000 investors, it is a crowdfunding situation, common in the West. This will call for a change in the Companies Law. Industry insiders say crowd-funding rules are not on the anvil, and given the level of financial literacy in the country, Sebi is not keen that many people participate in this asset class.