Here’s why startup founders and investors are praying for respite from ‘Angel tax’

A host of startup founders across the country have been asked to pay up large amounts as angel tax. Most do not have the cash, and are hoping for a Government intervention to save the day.

Bengaluru-based entrepreneur Aziz (name changed) was not very worried when he got a tax notice mid last year. He had to provide additional details of the angel investment he had raised in FY2014-15. But things escalated quickly.

The assessment officer, according to Aziz, decided that the valuation, which was based on performance projections, was too high. The funding raised was Rs 1.5 crore, and the officer decided that only Rs 1 crore would be considered as investment, and the remaining Rs 50 lakh as income – and Aziz would have to pay 30 percent tax on this.

Now there is an appeal process, and founders have to file an appeal within 30 days of the order being passed. Founders, however, have to pay up 20 percent of the fine or tax at the time of filing an appeal. Most founders, including Aziz, do not have this money.

There are many such stories across the country.

For the founder of an early-stage startup, raising that first round of angel funding is a big deal. It means someone apart from you, your co-founders and immediate family believes in your idea and, equally important, you now have the money to start building the business.

The last thing any entrepreneur wants here is to do the rounds of tax offices trying to convince officials that the valuation is fair, and that the angel money raised is investment, and not income. This is exactly what many entrepreneurs have ended up doing in recent months as tax authorities have come calling.

In Aziz’s case, the investment he made from his savings at face value at the time of starting the company was also questioned.

I was told that I should have put the same valuation as what I gave my investors when I raised angel funding. The tax authorities are saying the tax will be in multiple crores (the exact amount has not been revealed to protect the identity of the entrepreneur). I have not seen that kind of money in my entire life. How will I give that money as tax?” asks an anguished Aziz.

It was last year that many founders and investors took to social media platforms to raise this issue. As one spoke to another, they realised the large number that had been affected by this tax. Many of them got together, and formed a WhatsApp group to organise and jointly seek relief from the government. These founders have also reached out to organisations like iSPIRT and Nasscom for support.

“We are hoping thee government will help resolve this,” says Sreejith Moolayil, Co-founder of Pune-based TrueElements, who has had to deal with his own tax saga. He has now started a Change.org petition along with other affected startup founders.

My fair value

Sreejith had raised Rs 98 lakh in January 2015, and got a tax notice in October 2015. Since then, he has had to share numerous documents, all to justify the valuation at which the funding was raised.

Valuation of a startup lies at the heart of this problem. Most startups, which work on asset-light models, arrive at their valuations based on the Discounted Cash Flow (DCF) method.

Most founders raise angel money at a time when they don't even have a company incorporated… One can imagine the accuracy with which the revenue forecast is done when the company is just at an idea stage or on paper. If the company goes on to make revenues as projected or more, tax claims may not arise. However, if the cash flows don't happen as expected, tax officer can always say that the valuation was invalid and Fair Market Value is much lower and hence there will be tax on angel investment,” says Abey Zachariah, Co-founder and CEO of Goodbox.

In Sreejith’s case, the company did meet projections, but the assessment officer disputed the DCF method of valuation. Finally, in December, the company was told it would have to pay Rs 40 lakh as tax. To file an appeal, Sreejith wold have to deposit Rs 8 lakh.

We just closed another round of investment, so I have money with me now to file the appeal. When I told the tax officer about the new round of investment at 10 times valuation over last time, he told me I can expect another notice for that soon. This is an unending saga,” he says.

Another entrepreneur received a tax notice for Rs 85 lakh. His startup is making just enough money to cover working capital expenses for each month, and cannot come up with Rs 85 lakh, or the Rs 17 lakh that he will have to deposit to file an appeal.

Since most founders got final notices on December 28, they need to file their appeals by January 28, which means coming up with the 20 percent deposit by then. “The tax authorities can go after the personal assets of the startup’s directors if they don’t pay up. There is a person in our WhatsApp group who has shut his company, and is now an employee of a firm and he has been asked to pay Rs 85 lakh. People are extremely worried,” says Sreejith.

There is a provision that a startup registered with the DIPP is exempt from this tax. There are two issues here. One, very few startups are registered with the DIPP, says Padmaja Ruparel, President of Indian Angel Network.

Two, even this is being disputed by assessment officers. “We are registered with DIPP, and we got the notification from DIPP. But our assessment officer said the wording of the notification does not make it clear whether the startup is exempt or not. So we still have tax liability,” says Sreejith.

No country for startups

The effect of this tax is far reaching. For the startups affected, they have had to spend precious resources to deal with these notices. “You raise Rs 1 crore, and then you have to spend Rs 5 lakh for tax consultants and lawyers. This is an unnecessary distraction,” says Apremeya Radhakrishna, an angel investor.

Investors too are wary. Many angel investors have been asked to submit documents from bank statements to IT returns.

For most angel investors, investing is a part-time job. They have other pursuits. They are now saying, why take the hassle. Investments will come down,” says Padmaja.

It is only investment raised from Indian angel investors that is taxed. The idea is to prevent people from using startups to launder their black money. “But this is like killing many to stop a few,” says Goodbox’s Abey.

Now, the dilemma facing many startups planning to raise angel funds is whether to raise extra funds, so they can set aside some money to cover tax demands at a later date.

“Investors are not happy about that. They are asking why we should put in money to pay tax. The company is not even earning income, how can it be taxed?” asks Padmaja.

IAN, along with other angel networks, has suggested registering angel networks like venture capital funds, and exempting investments raised from such networks from tax.

The trouble is that it is completely up to the assessment officer as to what portion of the funding raised will be considered as income. The startup or investor, at the time of fund raising, has no clue. It is only when he receives the notices, which could be years later, that he gets to know what the tax bill is.

It is this discretionary power that is causing confusion. Apremeya says it is not just for angel tax that there is an issue. When TaxiForSure was sold to Ola in 2015, there was a no-compete clause.

There was no value or amount mentioned for this no-compete clause. We later found out we are supposed to pay service tax on this no-compete clause. The officer said the entire amount that we got for sale would be considered as the amount for this no-compete clause, and we would have to pay service tax on that. This is still going on. Again, an interpretation issue. All these startups will just register elsewhere. In Singapore, you can register in 10 minutes. The government needs to be startup friendly on the ground - Need to match words with action,” says Aprameya.

SoS (Save our startups)

Nakul Saxena, Fellow at industry body iSPIRT, says there is hope that the government will remove the discretionary power of the assessment officer as long as the company is certified under Startup India, as the certification will be done by a qualified CA.

The other main issue is Section 86, which pertains to the source of funds. Here, the demand is that the government come up with an accredited-investor category. Such investors will have a specific identification number, and startups raising funds from such investors should not be questioned.

 "We are hopeful. There are many in the Ministry of Finance who are willing to listen," says Nakul.

There is also hope that the government will provide immediate relief for startups who have received notices by allowing them to go through the appeal process without having to deposit the 20 percent, and that the process will be concluded in two months.

(with inputs by Sindhu Kashyap)