Obtaining funding for a startup is extremely difficult. It is said that startups receive money only from friends, fools, and family. However, there is another class of investors which provide money to these organizations. They invest in companies which are at very early stages of their product development. They belong to the same ecosystem as venture capitalists do. They have been nicknamed as “angel investors”.

Across the world, angel investors are viewed as being angels. This means they are viewed positively and governments offer various tax breaks to them for investing in early-stage companies. In the United States, the profits made from investing in one early-stage startup can be set off by reinvesting the money in another early stage startup.

However, in India, this is not the case. Here, angel investments are viewed with suspicion! This is the reason why there are no special tax breaks for angel investors. In fact, the tax policy is creating hurdles for such investments. As per the latest tax laws, startups will now have to shell out 30% of the funding that they receive from angel investors as tax. The amount will be added to the head “income from other sources” and be taxed at the maximum rate. Obviously, this hasn’t gone down well with the startup ecosystem. Startups and investors have started an online petition to pressurize the government to abolish this tax. In this article, we will learn more about India’s infamous angel tax.

The Logic behind Angel Tax

India has a big “black money” problem. India has a very low rate of tax compliance. This is because a large number of people evade paying income taxes. Only about2% of its population pay any form of income tax.

The tax department is therefore worried that angel investments are nothing but a form of money laundering. They believe that a lot of startup firms have assets which are off the books of the company. Investors are aware of these assets and hence they provide very attractive valuations to these startup companies. Startup companies have defended themselves saying that receiving attractive valuations is not a crime! Startups do not believe that they are generating any black money by evading taxes.

The tax department does not seem to believe this. Hence, they have their specialists who work out the fair value of a startup based on a predetermined formula. If the valuation received exceeds this fair valuation, then it is subject to the highest level of taxation.

The Certified Innovative Startup

The government of India is wary that their policies are damaging the commercial environment in the nation. Hence, they have come up with a policy which certifies innovative startups. If a startup company has this certification, then they are not subject to the draconian angel tax.

There are very stringent parameters to grant this certification. For instance, the turnover of the company must not be more than 25 million rupees, and the age must not be more than five years. Also, the company must be engaged in the production of an innovative product or service. The problem is that some of these parameters are subjective. Also, government officers in India have a reputation for being corrupt. As a result, less than 5% of the startups that apply for this certification are able to receive it.

The entire system has ended up being a mechanism to harass and fleece the owners of startup companies that are trying to make the world a better place and improve India’s economy while attempting to do so.

The Effects of Angel Tax

• The angel tax is interfering with the market mechanism. Investors are not able to fund ideas based on their merits. Instead, the funding is more dependent upon certificates and upper limits imposed by the government. The “Make in India” campaign introduced by Prime Minister Modi is of no use if this is the ground reality. India is trying to solicit investments from foreign investors while simultaneously having the most hostile environment for domestic investors.
• This is probably the only law in the world where equity investments are being taxed. All across the world, equity investments are considered to be the capital which will generate profits. Income tax is supposed to tax the profits and not the capital itself.
• The introduction of this Angel tax in 2012 has destroyed India’s startup ecosystem. In the five years since this tax has been introduced, the angel funding has seen a drop of over 55%. Number of companies being funded has dropped by 80% during the same period.
• A large number of India’s startups are incorporating overseas. This is because India has a favorable environment for foreign companies selling their products in the nation. However, for Indian startups, the environment is hostile. This flight of startups is leading to lost taxation revenue from the legitimate income that these companies earn.
• If the shares are issued at the fair market price determined by the government, it might lead to dilution of promoters control over the corporation. Startups, by definition, are asset light. They do not have the book value to justify a hefty valuation. Their valuation depends on other soft factors like the people involved, the technology involved, etc. This is the case across the entire world and is not specific to India. When no other country in the world is taxing startups, the Indian government does not have a moral right to tax equity investments by considering it as income.