Is There a Way Out From the Startup Tax?

Budget 2012 proposes to introduce several provisions to modify the current taxation framework applicable to venture capitalists – one amongst them being the startup tax (through amendment of Section 56 of the Income Tax Act). This provision has been criticized for the serious consequences it may have on angel investors, entrepreneurs and startups. Industry representatives have been considering making representations to the Government, requesting relaxations against this tax. While the Government frequently revises its stance on policy matters, it is more difficult for it to shift position on legislative provisions (the startup tax is a legislative proposal as it proposes to amend the Income Tax Act). Further, as budget 2012 indicates, the Finance Minister has been very aggressive on taxation recently (for example, the new budget has introduced various provisions which will adversely affect tax private equity transactions as well).So, we have looked for alternatives that could be available to angel investors to avoid the incidence of this startup tax, just in case the Government decides not to relax the provision. We answer the following questions in this post – is there a workaround the startup tax for angel investors? If yes, is the workaround practical and feasible for angel investors?

Registering a VC fund - the way to go for angel investors?

On the face of it, from a legal reading of the amendment, the only clear exception to this tax is for angel investors to register with SEBI as a VC fund. In case there is investment by such a fund, this tax would not have to be paid. This, however, comes with downsides as well. SEBI has recently announced a modification of the regulatory framework applicable to VC funds, which may make it more difficult (described in greater detail, later in this post) for angel investors to register as VC funds with it. Most individual investors and many institutional investors do not register with SEBI in India as a fund. In most cases, money is invested in personal capacity or through closely held companies. However, before coming to a conclusion, let’s discuss this option, and others, in greater detail.

Other benefits of registration – apart from exemption from the startup tax

Registration as a venture capital fund has other benefits under Indian law apart from preventing the tax consequences arising from funding startups under the new budget. For example, registration exempts an investor from the elaborate lock-in requirements in an IPO under Indian law. As per the lock-in requirement, when a company undergoes an IPO, the pre-IPO shareholding of non-promoters (including shares held by investors who have funded the company in investment rounds prior to the IPO) is subject to a lock-in of 1 year. These shares cannot be transferred, so an investor cannot ordinarily realize the value of his investment from an IPO for a further period of 1 year. A VC fund which is registered with the SEBI is exempt from this lock-in requirement. Angel investors who register as VCs with SEBI will be able to benefit from this exemption.

Critical considerations for angel investors before registration

Will it make sense for these investors to pool in some money into a fund first? The factors that will most strongly influence investors are the following:

- How much capital do they need to commit to the VCF at the beginning? How will pooling of funds work?

- How difficult/costly will it be to get a SEBI registration, and later on, to administer the fund/comply with SEBI regulations?

The newest problem in attempting to answer the two questions above is that the regulatory regime applicable to VC funds and other investment vehicles is transforming radically.

Overhaul of the regulatory regime applicable to VCs – which regulations apply?

VC funds are governed by the SEBI (Venture Capital Funds) Regulations, 1996 (“VCF Regulations”). However, on 2^nd April, SEBI issued a press release approving the draft regulations for alternative investment funds (“AIF Regulations”) proposed through a concept paper earlier last year (on 1^st August, 2011). (See my earlier post on Yourstory for a criticism of the draft AIF Regulations).

The AIF Regulations propose to revamp the framework applicable to investment vehicles, including VC funds. The finalized AIF Regulations have not been notified yet and are not presently in force, although they may be notified at any time. Once they are notified, venture capital funds will be covered by the AIF Regulations and the VCF Regulations would be automatically repealed. Funds registered under the VCF Regulations will continue to be governed by the same, until the existing fund or scheme managed by the fund is wound up. Any registration or approval granted by the SEBI under the VCF Regulations will be presumed to have been granted under the corresponding provisions of the AIF Regulations.

Until the AIF Regulations are notified, VCF Regulations continue to be applicable. Therefore, we have provided a detailed comparison of the relevant provisions of the VCF Regulations and AIF Regulations below.

Is it feasible for angel investors to register as VCs after the regulatory change?

SEBI has in its press release mentioned that venture capital funds have positive spillover effects on the economy, and that it may, along with the government and other regulators, consider granting incentives or concessions based on the need of the funds. I have briefly described the key differences between the AIF Regulations and the VCF Regulations below.

The AIF Regulations have drastically increased the minimum fund size from INR 5 crores to INR 20 crores, and the minimum amount that can be accepted from an investor from INR 5 lakh to INR 1 crore. The increase is significant – angel investors in India cannot individually invest more than about INR 20-25 lakhs. They may not be able to constitute such a large fund, and to pool these amounts.

Further, there are additional restrictions on the tenure of the fund, and heavy disclosure and record-keeping requirements that will significantly add to the costs of operating as registered entities. We are summarizing some key requirements which will be introduced by the AIF Regulations for the first time:

• The tenure of the fund shall be at least 3 years.
• Detailed information specified under the regulations needs to be disclosed to investors (such as financial, operational, risk management information relating to fund investments, details of regulatory proceedings or breach of information memorandum, etc.).
• The fund manager is required to address all investor complaints.

Is SEBI willing to be sensitive to angels?

Registration with the SEBI as a VC fund is the solution for angel investors to prevent falling under the net of startup tax. However, SEBI’s announcement to overhaul the regulatory framework for VC funds could make it impractical for angel investors to register with it. On the other hand, SEBI has stated that it will consider giving exemptions for VC funds depending on their need. It may be easier for angels to get relaxations from SEBI to register as VCs, than it is to hope that the tax on startups is withdrawn altogether. Angel investors and startups would need to adopt a consistent stand on the matter, so that they can make a representation to SEBI. Your views as a startup/angel investor will play a significant role in taking this discussion forward.

About iPleaders- iPleaders is currently working on solutions to make business law accessible to startups - through blogging, educational products and interactive softwares. It has started a diploma course (jointly with National University of Juridical Sciences, Kolkata, a top law university in India) to teach entrepreneurs how they can handle legal issues affecting business by themselves.