With GAAR and other anti-abuse provisions in the tax statute, it’s time to review some of the provisions acting as deterrent to investments into India.

With General Anti-Avoidance Rule (GAAR) and other anti-abuse provisions in the tax statute, it’s time to review some of the provisions acting as deterrent to investments into India.

Angel investing has been gaining significant momentum in the Indian start-up ecosystem over the past several years. For many entrepreneurs, the first source of funding for their infant start-ups comes from external investors.

In 2016, the value of angel and seed investments in India clocked $374 million for 901 deals; however, increased caution and selectiveness among investors halved the deal value in 2017 with only $245 million flowing in for 435 deals. Such low traction can also be attributed in part to the vexing ‘angel tax’.

‘Angel Tax’ stems from the provisions of Section 56(2)(viib) of the Income-Tax Act, 1961, applicable to closely-held private firms receiving equity funds. When such investments are made at a premium to the fair market value of equity shares, the provision seeks to tax the amount raised in excess of the fair market value. The amount is reckoned as “income from other sources” and taxed at 30% (plus surcharge and cess) in the hands of the recipient Indian company/start-up.

Angel tax has been long dreaded by the investor community and their chosen portfolio of investee entities. The Central Board of Direct Tax (CBDT) has recently granted some relief from this tax for start-ups that comply with conditions notified by the Department of Industrial Policy and Promotion (DIPP), government of India, in April 2018. These qualifying conditions have been stipulated for both the start-up and angel investors:

• For the start-up: Maximum cap of paid up share capital and share premium of Rs.10 crore;

• For angel investors: Minimum average returned income of Rs.25 lakh for the preceding three financial years; or minimum net worth of Rs.2 crore as on the last date of the preceding financial year.

In order to avail the exemption, a start-up would essentially first need recognition as an eligible start-up (following an approval process with DIPP) followed by a specific application to the Inter-Ministerial Board of Certification (‘IMB’), for approval to issue shares without triggering the angel tax provisions. For this, the application needs to be accompanied by a fair valuation certificate from a merchant banker.

At the time when the focus of the current government has been to provide start-ups with essential apparatus to grow through its ‘Start-up India Stand up India’ initiative, while the exemption notification from DIPP and CBDT provides some relief, it also throws up challenges for start-ups that wish to avail of such exemption.

First, the capital threshold of Rs.10 crore is likely to benefit only a small number of start-ups, thereby adversely impacting those start-ups that are involved in capital intensive businesses.

Second, the minimum threshold needs for angel investors can be deterring for small investors, who are looking to undertake their investment plans in individual capacity without being a part of any angel network fund.

Third, the requirement of valuation by a merchant banker also escalates the cost for start-ups and angel investors.

Fourth, start-ups would have to go through the administrative hurdle and multi-stage approval process required for availing exemption from the angel tax (viz. DIPP registration followed by IMB approval).

Lastly, the exemption notification eases the nerves of only future investors looking to invest in certified start-ups. The Department of Revenue (DoR) earlier this year issued a notification directing assessing officers not to take coercive measures on recovery of angel tax against registered start-ups. However, unregistered start-ups, who have already raised angel investment, may continue to find themselves in the crossfire with the income tax authorities, resulting in pro-longed disputes and litigation vis-à-vis their investments.

These provisions of taxing the excess premium under the head “income from other sources”, was introduced with the objective of targeting shell firms and sham deals.

However, this is now adversely impacting genuine investments made in start-ups as well as other merger and acquisition-related transactions, thereby running counter to the government’s initiatives of promoting ease of doing business in India and start-up India action plan.

With GAAR and other anti-abuse provisions now effective under the Income Tax Act, the provisions of angel tax seem to have outlived their utility. There is, therefore, a need to revisit the rationale for continuing with this tax provision, which is actually hampering the flow of domestic investments into start-ups. In the meantime, there is a case for allowing eligible start-ups a blanket exemption from the tax without requiring to undergo the approval process (as of 4 January 2018, 6,096 startups have got registration with DIPP/IMB, with only 74 getting tax exemption).

The government-led initiative of ‘Startup India’ has grown leaps and bounds from when it was first announced in January 2016. For entrepreneurs and the start-up community, angel investors are significant stakeholders and growth propellers. It is, therefore, imperative that further headways are made in aligning the Indian tax laws with a progressive and pragmatic economic outlook. In the interim, investors and start-ups both need to plan their investments appropriately bearing in mind the exemption conditions specified by the recent government clarification.

What is the underlying corporate tax rate for start-ups?

The applicable tax rate on start-ups depends upon the choice of entity through which the business is being carried out. In case of limited liability partnerships (LLPs) and companies, the base tax rate is 30%. For specified firms i.e. those with gross turnover of up to Rs.250 crores in fiscal 2017, the rate is reduced to 25%. In case of proprietorships, the income is chargeable to tax at individual slab rates, with highest slab at 30%. Additional surcharge and cess will apply.

What all tax exemptions and incentives are available for start-ups, in addition to those for angel tax?

There is a profit-linked tax deduction for three years for eligible start-ups, subject to IMB registration (for both firms and LLPs). Additionally, investors are eligible to claim capital gains tax exemption for specified investment in start-ups, subject to the provisions of the Income-tax Act.

What other instruments may be used by start-ups for issuance to foreign investors other than equity?

In addition to equity, start-ups may explore issuing compulsorily convertible preference shares, compulsorily convertible debentures and optionally convertible debentures to overseas investors. It may be noted that issuance of OCDs by other firms (viz. other than start-ups) is restricted as it gets covered under RBI’s ECB regulations.