Demystifing angel tax for startups

Angel tax was introduced by the UPA government finance minister, Pranab Mukherjee, in 2012 to fight against money laundering. Startups are majorly funded by friends, family and outsiders, particularly angel investors. This might provide an avenue to opportunists for converting their black money into white.

The government then introduced angel tax on startups. It is levied at the rate of 30% under section 56(2) of the Income Tax Act, 1961. It is defined as the income tax payable on excess of amount received in lieu of shares over the fair market value of shares of the unlisted companies. FMV is determined by the tax officials themselves. This ends up making the valuation process arbitrary and less objective.

Angel tax has ever faced criticism of startups and investors. It is seen by them as a hindrance to growth of startups, which provide a major boost to Indian economy. In Dec 2018, around 2000 startups received notices from CBDT demanding taxes on investments. There was a huge hue and cry among the investors.

Keeping this in mind, the Department for Promotion of Industry and Internal Trade (DPIIT) has made various amendments to provide respite to the aggrieved. The most recent ones are listed below:

1. The definition of eligible start-ups, those who qualify for exemption from angel tax, has been modified.

• Any entity will be considered as a startup upto lapse of 10 years from its incorporation, as against 7 years earlier.
• Any entity with an annual turnover of Rs 100 crores (25 crores earlier) or less will be considered as startup.

2. The threshold limit for paid up capital has been increased to 25 crores as against 10 crores earlier.

3. Startups do not require certification from the inter ministerial board now. The new applications will have to be routed through DIPTT and evaluated by CBDT.

4. No exemption for start-ups will be made available if the investments are made in following assets:

• Land and building for any other purpose than use by business
• Loans and advances other than those extended in the normal course of business
• Capital contributions made to other entities
• Motor vehicle, aircraft for more than Rs. 10 lakhs for any other purpose than use in business

Let us now understand the methods of valuation of startups:

Net Assets Value (NAV) method:

The net asset method is based on difference of fair value of assets of the business and its external liabilities. The point to be considered here is determining fair value of assets as their acquisition cost might differ from book value. The amount available to equity shareholders divided by number of equity shareholders is used to find net asset value per share.

Discounted Cash Flow (DCF) method:

Discounted cash flow method is one of the widely accepted methods of valuing startups. It discounts the future cash flows of an enterprise to its present value. Although it is a logical and widely accepted method, it comes with certain limitations. The cash flows  from a tangible business asset like plant& machinery can be reasonably calculated. This is not true for intangible assets whose values can be inflated by the enterprise.

By and large, DCF method gives a fair range of value of startup.

It can be concluded that the steps taken are for the larger benefits of startup community. These will pave a way for more startup friendly regimen.