What exactly is angel tax all about?
To understand the concept of angel tax, we need to understand that the valuation of start-ups is quite complex. For example, how do you value companies like Flipkart and Ola which have made a huge impact but are still making massive losses. Obviously standard metrics cannot apply. However, angel investors are willing to pay top dollars for start-ups where they see a possibility of major disruptions in the future. The concept of angel tax first came about during Pranab Mukherjee’s 2012 budget. The angel tax is a 31.2 % tax (30% tax plus 4% cess) levied on investments made in start-ups in India. Any amount paid by the angel investor in excess of the fair value is liable to angel tax
For example, if an angel investor takes a 20% stake in a start-up for Rs2 crore and the IT department assesses the fair value of the company as Rs6 crore, then the excess paid for the 20% stake (Rs80 lakhs in excess of fair value) will be liable to angel tax. Since this angel profits are treated as “Income from Other Sources”, they are liable to the peak rate of tax applicable. The problem with Angel Tax is more of perception. The angel investor may pay top dollar for the company based on its future cash flows, product potential, disruption potential, brand built, barriers created, etc. The IT department may only consider the fair value based on future cash flows. This could create a perception of overpayment and put a huge tax burden on the start-up in such cases.
What is the global experience on taxing start-ups?
Interestingly, governments across the world have been trying hard to inculcate a start-up culture to encourage such start-ups and angel investors with appropriate incentives. Let us take the case of China, which has produced some amazing start-up stories in the technology sector like Alibaba, Tencent, Baidu and Snapchat. The Chinese government has used preferential tax policies that allow 70% of total investment to be deducted from taxation two years after investment in case of high-tech business lines. Even Singapore, which is emerging as a preferred start-up in Asia offers tax incentives to start-ups and angel investors, in the form of tax exemption in the first three consecutive years. Other countries like Germany, Australia, Israel and UK also offer generous incentives for start-ups.
Why angel tax in India looks incongruous
Considering the direction the world is moving towards on start ups, Indian angel tax policy runs the risk of stifling entrepreneurship and angel investing. This point has been underscored by start-up associations, lawyers and VCs and PE funds. Most unlisted and early-stage start-ups rely on angel investors to build the groundwork necessary to get further funding from venture capitalists. Remember, angel investors not only bring in funds but also bring in expertise, management bandwidth, best practices and a complete ecosystem. The angel tax looks incongruous when the government is trying to encourage start-ups.
One of the key requirements of encouraging start-ups is to have an enabling tax environment and, more importantly, prevent start-ups being hounded by the tax men. The angel tax does exactly the opposite. The sooner the government addresses this issue, the better it will be.