Angel Tax: startups and investors are running out of patience after CBDT move against two startups

It was 8.00 am on February 5 and Pushpinder Singh, Co-founder of Travel Khana, was running from pillar to post trying to figure how he would pay his employees their salaries on time. His bank account, which had the required sum, was depleted after the Central Board of Direct Taxes (CBDT) withdrew Rs 33 lakh that it said was due as tax remittance. Worse, another of Travel Khana’s account, with SBI, was frozen. 

“After a few conversations with bank officials, we realised the tax officials had coerced them to share the details, and then freeze the accounts,” Pushpinder told YourStory. 

Travel Khana is not the only one. Siddharth Ahluwalia, Co-founder and CEO of Babygogo, recently received a message that Rs 72 lakh had been deducted from the company account by the CBDT. 

What is more disturbing, say startup founders, is that this occurred just a few days after round table discussion with representations made by Angel and other investors, fund managers, entrepreneurs and the CBDT to help ease the situation with the Department for Promotion of Industry and Internal Trade (DPIIT, formerly DIPP). What’s more, a CBDT circular, distributed in January this year, said no coercive action would be taken against a startup until the regulation on taxing them is clear. 

Also read: YourStory’s Exclusive Interview with Prime Minister Narendra Modi (and what he had to say about startups)

Since then, investors, founders and mentors have taken to microblogging platform Twitter to highlight the issue of Angel Tax. 

Under heat, tax officials acted quickly, and the CBDT quickly moved to unfreeze Travel Khana’s account. The debit, however, has not yet been reversed. 

As reported by YourStory earlier this week, DPIIT is likely to very soon issue a circular with rules that will provide a blanket exemption to startups that are up to 10 years old from such notices.

Angel Tax is not the only menace 

The problem with Travel Khana and Babygogo is not just about Section 56 (2 vii b), better known as Angel Tax. The two saw action initiated under Section 68 of the Income Tax Act, 1961, as well. 

Siddarth Pai, Founding Partner, 3one4 Capital, sheds light on the issue, and Section 68, which talks about unexplained cash credits. He says the section states that if a startup or a private limited company has any credits, including any share premium or share capital, the receiver needs to establish the identity and creditworthiness of the investor.

Section 68 is an anti-abuse measure, and unlike Section 56 (2 vii b), doesn’t talk about valuation. 

“In the case of Travel Khana, they got a notice under this section. The problem here is that the assessing officer makes the startup founder the intermediary between them and the investor. They ask the startup to share three kinds of documents to establish identity and creditworthiness – investors’ bank statement, financial statements, and income tax returns,” says Siddarth.  

However, startups and investors alike say this information is confidential and not shared with a startup founder.

Caught between a rock and a hard place

Siddarth says the government needs to change its stance here and that a startup only needs to give basic information about the investor to the assessing officer. It should then be the IT officer’s job to get the investment details directly from the investor. 

In Travel Khana’s case, the CBDT says it had sent several notices to the founders seeking details of the investors and their bank details. In response, Pushpinder says, 

“There were no ‘cash’ transactions. Section 68 of IT Act is being applied on us, which is designed against “unexplained” cash deposits. Each transaction came through bank transfers or equivalent. Each of our investors is valid, with bonafides authenticated, and we raised the funds from Letsventure.com (LV). LV is a reputed and respected platform for Angel investments. Additionally, many of our investors in the round mentioned are highly respected public figures.”

While the government is making moves to salvage the situation, one of the biggest concerns for startup founders now is - Is this the environment I want to build my startup in? 

Shanti Mohan, Founder, LetsVenture, which is one of the key investors in Travel Khana says, 

“The department should provide enough time for appeal and take action only if there are serious financial irregularities. While the DIPP (now DPIIT) has been in conversation with the various stakeholders, there should have been a stay on such coercive measures to the startups.”

A founder in Bengaluru, seeking anonymity, says seeking details from investors puts them in a fix. “The investors are not obliged to share any of their bank transaction details with us. At best, we can share the name, contact details, and PAN details of the investor with tax officials. After that, the ball is in their court. If they deduct money from our account, it is big hit to our businesses.”

The problem is that the guidelines around such taxation has never really been clear, and despite repeated assurances, startup founders are still being penalised.

“It is like being caught at both ends. We have Angel Tax on one side, where we need to validate valuation and investments, and then Section 68. Can there be more clarity of what is expected from a founder?” a Bengaluru-based startup founder told YourStory on condition of anonymity. 

Indruj Rai, Partner at law firm Khaitan & Co, believes there is a different problem at play here.

“The government doesn’t want to do away with Angel Tax. There have been some submissions made to do away with the tax since there is already Section 68, which says a company (including startups) should be able to prove the genuineness of the source of investments received and also prove genuineness of source of such money in the investor’s hands.” 

As Siddarth points out, “Section 56 (2 vii b) says if you are a private limited company issuing shares at a premium, the difference between the price at which you issued the shares and the fair market value of the share is taxed as income in your hands.”

Also read: Angel tax: The fear of money laundering must not stunt investments in early-stage startups

He says, two types of investments, though, are excluded – SEBI-listed VC funds and investment from a non-resident. DTIPP-registered startups are also currently exempt. Unfortunately, not all startups are DPIIT registered, and not everyone gets funded from SEBI-listed VC funds. 

To address this, LetsVenture recently launched an Angel Fund (subcategory of cat-I VCF, which is regulated by SEBI) – a vehicle through which all its investments are routed. “The Angel Fund prevents the startups from getting hit by the Angel Tax issue (which was one of the key reasons for us to start the fund),” says Shanti. 

For others, Indruj advsises,

“My advice to startups would be to get registered by DPIIT nonetheless. Further, when startups get a scrutiny notice asking for more information on a certain transaction, the first time, they should provide enough documentation with a case well represented by an external counsel.”

Startups feeling left out in the cold

The mood in the startup community is one of wariness, especiallly after the incidents with Travel Khana and Babygogo, both of which are not DPIIT-registered.

“When something like that happens, it reduces the trust in the stakeholders and policy makers,” an early-stage investor told YourStory on condition of anonymity.

For Travel Khana and others like it, their very existence is in question.

“While the accounts are no longer frozen, there is no money in my accounts to run day-to-day operations. For an early stage startup, Rs 33 lakh being deducted from our accounts has affected our business. I have been told it will take a few months for the issue to be sorted. But for a startup, a few months can kill us,” says Pushpinder. 

The startup community, has joined forces to help. Pushpinder says alumni from IIT have offered support, and many are even ready to give him short term loans. however, he is looking for a long-term solution.

“It effectively even cuts off investment from other investors, as it is an ongoing case. So, investors worry that whatever they pump in will not be used for growth of the company but to resolve existing issues,” says Siddarth, adding that data from 2015 to 2018 shows that the number of unique Angel investors has fallen by 48 percent. 

“If you look at the deal data, the number and size of deals in early stage deals has also reduced. While the other rounds are increasing, the Angel and early stage investments are drying up. Currently, the number of Angel investors backing off from investing in startups is steadily increasing,” he says. 

Rajesh Sawhney, noted mentor, Angel investor and Co-founder of InnerChef, said on Twitter that he will not invest in startups until the government provides clarity. He will continue to mentor startups, though. 

“You (the government) are effectively killing startups. With no early stage investments, how can a startup ecosystem flourish,” says a founder, who currently is seeking angel investment. Another founder is thinking of moving overseas:

“I am, in fact, thinking of registering my startup in Singapore or in San Francisco. As a founder, I don’t need income tax benefit, I need Angel Tax to be removed. It will make it easier for my startup to raise funds, and focus on developing my product if it is out of India.” 

Despite numerous assurances, what remains be seen is what the government will do to sort the issue out once and for all – and not just of Angel Tax, but of Section 68 as well, for the danger here is that two sections of the IT Act can kill an ecosystem that is just about beginning to mature.