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Tuesday, March 20, 2012

Govt levies 30% tax on start-ups receiving angel investment

My colleague Beryl Menezes contributed to this story which appeared in DNA Money edition on Monday, March 19, 2012. 

Entrepreneurs looking to raise angel or venture capital funding for their respective start-ups will not be very pleased with a recent amendment being made to Clause 21 of Section 56 of the Direct Taxes by the finance minister. As per the new ruling, start-up companies will now have to pay tax at the rate of 30% on investments received from angel investors and non-registered venture capital funds operating in the Indian market.

Saurabh Srivastava, co-founder, Indian Angel Network (IAN) believes this clause is extremely ill advised and has probably been triggered by the 2G scam. “Unfortunately, it is the equivalent of dropping an atom bomb on a city because one criminal needs to be killed. This clause will completely kill all angel investment in the country and, with that, spell the death knell of first generation entrepreneurship that had begun to mushroom over the last few years,” he said. Indian Angel Network has thus far invested in over 30 start ups in the last 6 years.

While the clause exempts venture capital firms that are registered with the Indian regulator - Securities and Exchange Board of India - SEBI, there are a host of such investors are not registered in India and funds raised from such firms will be taxed by the IT department.

The clause however, makes a big dent on funds being raised from angel investors operating in India because none of them are registered. Actually, there is no such category with the Indian regulator that allows this set of individual (angel) investors to register.

“I have over a dozen such (angel) investments in my personal capacity but I am not a registered investor. In fact, if this clause was in existent earlier, Spectramind wouldn’t have happened and so would have a host of other entrepreneurial initiatives that have shaped up in the last decade or so,” said Raman Roy, member, Indian Angel Network (IAN). Roy was also the founder of Spectramind which pioneered the concept of business process outsourcing (BPO) in India back in 2000.
Ravi Mahajan, partner, tax and regulatory services, Ernst & Young India, feels while the provisions have been introduced to track black money, it would negatively impact genuine angel investors. “Only venture capitalists have been exempted from this amendment and any valuation more than the fair value will be taxed. This will adversely impact angel investors, if funding is based on valuation that IT authorities don't agree with, then the companies will have to pay the difference between the forward-looking investment by the angel investor and the valuation as assessed by the Income Tax department, as tax - even if they do not make profits on the same. This will thus become a cost funding for the small companies, affecting their profitability. Cost of tax would also lead to longer break-even time for smaller companies,” said Mahajan.

Angel investors generally act as catalysts by making available the initial capital - starting from Rs 10-20 lakh to a crore or more - to new start-ups with a good business idea. These set of investors work towards promoting entrepreneurial initiatives by providing the much needed financial support and ensure such activities continuously flourish in the country. However, various measures enunciated for small and medium enterprises (SMEs) will now come to naught because of this one clause, feels the angel investor community.

“This is because angel investment precedes venture capital investment. For VC's to fund 10 companies, we need 1,000 entrepreneurs to be funded by angels. It is common knowledge that when you fund an entrepreneur who just has an idea and not much else, the definition of fair market value cannot possibly be determined by any valuer and certainly not by a tax authority but only resides in the minds of the entrepreneur and the investor. A tax officer could legitimately see the value as close to zero, whereas any angel investor who chooses to invest will do so because he / she sees great value and would buy shares at a huge premium because they would want the entrepreneur to hold a majority of the company,” said Srivastava.

Roy added, “What the clause does now is that, when we invest as an angel in a company, the income tax (IT) officials will raise questions about its networth. Start-ups are about ideas and concepts with no assets that can be quantified as its networth in the market. Angel investors pay for the idea which is yet to take the form of a commercially viable business model. Google was created as an idea with just $10,000 and the company is worth billions of dollars now. If the same $10,000 was to be given to an entrepreneur in India now, the IT department will impose a 30% tax on the money raised.”

The angel investment community asserted that rather than giving them a tax break for making such risky investments for creation of wealth and employment - as is done by most countries in the world - the Government in effect is taxing them and therefore, encouraging them to put their monies in unproductive assets like farm houses and real estate.

Sageraj Bariya, managing partner, Equitorials, a stock market advisory, research and training firm, said that the move will be contrary to the Government's aim of providing more jobs, as this would dampen entrepreneurial aspirations. “The Government does not have the right to decide the valuation of a company, and this is certainly not the solution for the problems that arose from forward-looking foreign investor funding, like in the case of Telenor-Uninor, which now have their licenses cancelled as a result of the 2G scam. This move will make foreign private equity companies think twice about investing in India, which will curb investment opportunities.

“Additionally, smaller companies - like many small IT firms who have gone in for this mode of operation - will face problems in attracting new capital. So for example - a partnership like Infosys and OnMobile, may not happen as frequently as before, as these larger firms would cut their investments to avoid taxation. The need for small IT companies to move from a services-led to product-led category, by getting funding from angel investors will also be significantly impacted by this move," said Bariya.

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