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.