Angel Tax is gone but the fine print still reveals challenges for startups

Angel Tax will not be applicable to DPIIT-registered startups. While that is considered half the battle won, the ecosystem is still grappling with other Income Tax concerns.

29th Aug 2019
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Finance Minister Nirmala Sitharaman’s announcement on August 23 that the Angel Tax is inapplicable to startups registered with the Department for Promotion of Industry and Internal Trade (DPIIT) may have come as a big relief for the ecosystem, but the fine print reveals that unresolved issues still persist.


While the Angel Tax, which was introduced in 2012 under Section 56(2)(viib) of the Income Tax Act, 1961, may be set aside for DPIIT-registered firms, other Income Tax (I-T) ambiguities have the startup ecosystem reeling.


Critical aspects like long-term Capital Gain Tax, exemption from negative list of investments, high penalty on a transaction where share premium is involved, and protection from investigation of the I-T department officials are still bothering India’s entrepreneurs.


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Take, for instance, the tax on capital gains. Ritesh Banglani of Stellaris Venture Partners, tweeted, “Ok Just read sections 111A and 112A and it’s clearly for listed stock only. This means that gains from startup investments will be taxed at 28.5 percent while those from listed equity investments are taxed at 11.9 percent.”


This comes as a big dampener for the investors in the startup ecosystem as it would slow down the exit process given the high tax they would have to pay. It may also discourage angel investors from putting their money into startups.


Siddarth Pai, Founding Partner, 3one4 Capital, says, “The removal of surcharge by the government is only for the foreign portfolio investors (FPI) and startup investors will continue to pay capital gain tax twice the rate which is normally levied.”

Angel Tax has been a bone of contention for the startup ecosystem ever since it was introduced. The Section of I-T Act was applied by the department to ask startups to pay tax on the investments they have raised.


Many startups that raised funds also received demand notices from the Central Board of Direct Taxes (CBDT). While the clause does not apply to startups receiving funds from registered venture capital investors and alternative investment funds in the AIF–I category, the industry wanted the scope of the exemption to be expanded. 

Challenge of conditions


While the government’s move to come out with a series of measures to lessen the impact of Angel Tax on startups has been lauded, the conditions put out in the circular in February has raised some concerns.

For example, the circular cited exemption from Angel Tax provided the DPIIT-registered startups do not make investments in land, buildings, work yards, aircraft, cars, etc, unless they are in the ordinary course of business. While this was considered largely reasonable, certain conditions to this rule have set off alarm bells, namely the clause stating that startups cannot provide for any loans or advances, nor make investments in mutual funds, along with prohibition of capital contribution and creation of subsidiary.


An investor says, “If any founder makes these kinds of investments, the tax authorities are going to come after you and the exemption is withdrawn.”


Penalty


In case a startup makes an acquisition through a share transaction, there is a possibility that there is a penalty payable at the rate of 200 percent, which is calculated on the stock premium of the deal.


There have been cases where startups are exempted from Angel Tax, but are questioned for the above mentioned transactions.


Siddarth says, “These issues have not yet been solved, and unless the government rectifies the circular, there will not be much change at the ground level.”


There were scores of startups which received Angel Tax notices though many of them did not want to state their cases publicly except for a few exceptions like Babygo and Travelkhana.


Positive lift


At the same time, the recent announcement by the Finance Minister about Angel Tax has certainly brought in a positive sentiment to the startup ecosystem that was battling the I-T Act provision for years now.

Sachin Taparia, Chairman, LocalCircles, echoes a similar sentiment. “This has definitely put a lid on the whole issue and is a positive action. Appeals from startups are getting upheld and no notices are being generated under the provision of Angel Tax,” he says.

However, some feel that further communication from the government is needed on Angel Tax. An industry representative on condition of anonymity says, “The Finance Minister’s announcement should lead to a complete burial to the Angel Tax issue though a clarification is needed whether it is applicable for the companies that have already got the I-T orders.”


The question now remains whether the August 23 announcement will have an impact on the funding momentum for the Indian startup ecosystem, which has often found it challenging to raise seed-stage funding, especially in recent times.


Sachin says, “In the short term, there may not be much improvement in the seed stage funding due to the overall economic situation.”


Another investor opines that despite the positive sentiment, it is unlikely that any big push for seed stage funding will happen soon. “There has been lack of exits at the seed stage of funding for startups and this has prevented the inflow of investments. It is unlikely to improve anytime soon,” he says.


In her August 23 media brief, Nirmala Sitharaman assured the startup ecosystem that no coercive action will be taken to recover tax demands. She also promised a dedicated cell under CBDT to clarify and address issues faced by startups.


Now it remains to be seen how the government is going to respond to taxation concerns of the startups in the country.




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