Boosting the startup ecosystem as a solution for India’s employment woes has been a much touted objective of the Modi government since it came to power in 2014. One of the neck-aches the government and startups inherited from the tax regime was the burden of uncertainty over how investments by resident Indian individuals in startups are taxed. Introduced in 2012 by the UPA II regime to counter money laundering, we are yet to successfully address the unintended consequences that startups/investors continue to suffer.
To its credit, the Modi government has brought in a series of well-intentioned changes. Despite this, startups and investors alike continue to be slapped with assessment orders from the IT department, which has been discouraging for fresh domestic investment in startups. Here we seek to summarise how far the Modi government’s efforts have gone forward in liberating genuine businesses from the tax man, and think about what needs to be done.
Startup India Standup India
It began in January 2016, when Prime Minister Modi took a significant step towards fulfilling his party’s election promise of improving the ease of doing business in India. The Startup India Action Plan was announced before a crowd of leading representatives of the country’s startup community. It was a clear signal of intent; the plan pointed towards easing of compliance, the formation of a Startup India hub, legal support, accelerated patent examination, tax exemption for startups, and financial support through a Fund of Funds Corpus. However, much of the Startup India programme was limited to that - a statement of intent and did not move forward with clear statutory/policy prescriptions as we had written about at the time.
One of the key takeaways of the action plan was the move by the government to address the issue of Angel Tax by exempting startups registered after April 1, 2016.
While this seemed like a promising start, trouble began as startups struggled to register themselves with the Department for Promotion of Industry and Internal Trade (DPIIT) and until 2017, only only 900+ startups startups were able to register. Today, the official registry lists approximately 14,000 startups . The vast majority of startups which remain unregistered or were set up before April 1, 2016, continued to receive assessment orders from the IT Department during this time.
Attempts at course correction
The disruption in the playing field was stark and numerous startups still face difficult questions over their valuations today. In fact, in a recent survey by the online platform, LocalCircles, and Indian Venture Capital Association (IVCA), around 73% of over 2,500 startups and entrepreneurs said that they had received at least one angel tax notice. To this end, the DPIIT held extensive discussions with industry experts, SEBI, and other key stakeholders before creating a new framework that aimed to eliminate this discrimination.
Through a notification issued in April 2018, the DPIIT declared that startups registered prior to April 1, 2016, will also be exempted from angel tax implications. The investment bar was also raised from the existing Rs. 5 crore to Rs. 10 crore. Expectations ran high in the run-up to the 2019-20 budget. There was growing clamour around the continued application of Angel Tax on startups in spite of the previous changes in procedure. In January 2019, DPIIT modified its previous notification with a fresh definition for investors, which would need to be satisfied for a startup/the investors who require exemption. Now investments could only be made by individuals with a minimum annual income of Rs 50 lakh and net worth of at least Rs 2 crore. The DPIIT, however, continues to chip away and a recent notification has brought relief to startups by increasing the investment limit to Rs 25 crore and eliminating the requirement for approval from the IMB, allowing them to proceed with the investment.
Well-placed intentions, misplaced actions
At this point, it’s safe to say Angel Tax has caused more trouble than it’s worth. As we look back, it is quite clear that the tax appears to be fairly naive and ill-thought out, with unintended consequences affecting more people than its intended targets. The current regime recognised this problem early on as they set about cutting through the clutter of compliance and regulations faced by startups. They have done well to listen to the voice of their entrepreneurial audience in this matter, but we are yet to see a fair translation of their expectations. In their bid to retain the essence of the law and keep their guns trained on its original recipients, the collateral damage could only be minimized over time, but never completely eliminated. Most of the attempts made so far by the DPIIT have only made it more cumbersome for startups to avoid a tax they shouldn’t be required to pay in the first place.
There are certain issues that draw our attention at this point:
DPIIT seems to be well-intentioned in attempting to define “startups”. Defining the exemption for a class of businesses has been the guiding thought process during the Modi government’s tenure. This explains why the government requires startups to register, the ostensible reasons being that only genuine startups (and not laundering shops) should avail of the exemption. There are however several issues with this approach. By seeking to define “startups” in narrow terms such as how recently they were incorporated or the nature of their business, other small and medium sized businesses who require capital for genuine business needs get excluded and are treated differently for no real discernible reason. If the objective is to prevent money-laundering, the focus should be on identifying what constitutes a genuine fundraising exercise in an actual business versus actions aimed at avoiding taxes by investing in shell companies. This is not as difficult as it sounds, it will require some imagination in terms of rule-framing and constructive interpretation that evolves as we go, by tax authorities and courts.
DPIIT has recently been defining “investors” who can invest in a startup for the startup to be eligible for the angel tax exemption. It is unclear why DPIIT is entering into this area of regulation. The thought process seems to be sound - high risk high return investment opportunities should only be open to high net worth individuals who can bear the risk of failed investments and/or who have sophistication to invest in startups. However, this is a matter of securities regulation and not tax administration. India’s securities regulator - SEBI should be bearing the burden of regulating early stage private equity. Neither is it within the competence of DPIIT to regulate these matters, neither does it fall within its mandate. Just as the SEC does in the US, SEBI must take the lead in this situation and establish a clear guideline for investors to follow before being accredited to invest. There are recent indications that the government is recognising this and may act on it. The fear will be, as it always is in India, that well-intentioned regulation will be highly susceptible to teething problems, over-restrictive starts and collateral damage to industry. Any regulatory framework for angel investing should be established carefully through SEBI’s public consultation processes and take along all stakeholders.
It is also high time that the government recognised that (a) the startup/investor definition doesn’t exclude money laundering operations, who do not need to go through many hoops now to register as a “startup” and carry on the mischief it was supposed to prevent. At the same time, it also excludes any bona fide businesses who require capital who just fall outside the startup definition, but which are NOT money laundering operations.
What is perhaps called for is a guiding principle that brings in a level playing field for all organisations - young and old startups and other companies alike. As long as a company and investors are carrying on a genuine business with no intent to avoid tax, there should be no reason for them to come under the scanner of the IT department. This may require approaching the money laundering issue conceptually rather than through inclusion/exclusion processes. This would mean defining investments that come under scrutiny in broad terms, such as if the business is a sham and there is an intent to avoid taxes, much like the GAAR (general anti avoidance rules) seeks to do with counter international money laundering.
There is always scope for good old fashioned legislation where you clearly identify the mischief and set the right expectations in terms of compliance, rather than go in circles defining exemptions and exceptions to nowhere.
We hope that there will be light at the end of the tunnel.