Arecent series of so-called “angel tax” notices received by start-ups have caused consternation. Under Section 56 of the Income Tax Act, the tax department can investigate start-ups to see if they are conduits for tax evasion and money-laundering. However, the laws as they currently stand have a very negative impact on sentiment as they go against the spirit of the Start-up India initiative of the government. While the Central Board of Direct Taxes (CBDT) has agreed to refrain from coercive action against start-ups after a high-level intervention from the commerce ministry, the possibility of angel tax being levied remains since the law has not been amended. Moreover, start-ups that have already received notices will continue to face scrutiny and possible harassment. This problem has existed since 2017, when start-ups first raised concerns about the way this section could be interpreted. In effect, any investment in a start-up could be considered an attempt to launder profits. The crux of the issue is that the interpretation depends on the discretion of IT officials. In other words, if an officer decides that equity investments have been made at above “fair-value”, they may raise a demand to tax excess valuation as profits.
But start-up valuations are extremely fuzzy. Indeed, the valuation of any unlisted business is tricky. There is no such thing as a hard and fixed “fair value” for businesses, which, by definition, have low or zero revenues. Valuation is especially difficult for services since those tend to be asset-light. Early investors such as angels, private equity investors and venture capitalists make valuations based on individual projections of business potential and future growth. They are frequently wrong in their judgments and the vast majority of start-ups don’t live up to their expectations. But the few that do turn profitable yield enormous returns, which compensate for the many failures. It is also possible that any given start-up will absorb several years of losses before it starts generating profits. This was the case for household names such as Amazon and Facebook. Indeed, Twitter and Flipkart still remain loss-making propositions. Angel investment is, therefore, based on a classic risk-reward equation where the investors take large risks in the hope of making extraordinary gains.
Given how the ecosystem functions, most start-ups will not qualify as being fairly valued in the eyes of the taxman. The law, which places the onus on a start-up and its investors to “prove” that it is fairly valued, is regressive since it sets standards that are more or less impossible to meet. The net effect is that it stifles innovation. It scares away investors and prevents entrepreneurs from raising funds. A flip-flop policy of raising demands, and then soft-pedalling scrutiny, doesn’t really repair damaged sentiment. There is always the fear of another cycle of coercive investigations. Moreover, the law discriminates against companies registered in India since it doesn’t investigate start-ups registered abroad. Again, this creates an incentive for entrepreneurs to head out to tax havens. The CBDT has said it is preparing a circular to clarify these issues. A committee of experts is being set up by the government to examine the eligibility of tax exemptions for start-ups. The sooner this is done the better. Innovation and risk-taking should not be smothered by the application of an unimaginatively drafted law.