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Politics

India's 'angel tax' bedevils startups

Companies slapped with a heavy tax and penalties on funds raised since 2012

Entrepreneurs and freelancers work inside Innov8, a co-working space in New Delhi.   © Getty Images

BANGALORE, India -- Sreejith Moolayil had a rude shock in December when his health-food startup True Elements received a tax bill of $61,500 on roughly $155,000 it raised in January 2015.

But the Pune-based company is not the only company to be slapped with the government's so-called angel tax. Startups in India are protesting after the country's tax office enforced a 30% income tax on the difference between the actual amount these companies raised in seed funding and what it perceives as "fair market value" for them.

According to India's Income Tax Department, True Element's fair market value was just $1,500, calculated as the book value of the assets it owned. That meant the difference between its fair market value and the amount it raised based on a discounted cash flow valuation was around $153,000. The tax demand of $61,500 also included punitive penalties for late payment.

Moolayil said that he had made over 15 visits to the tax department to plead his case but to no avail. "We tried to explain why discounted cash flow valuation is appropriate and not net book value method for a company like us, which is asset-light and runs on software applications," he said.

Discounted cash flow valuation projects future cash flow and discounts it, using the cost of capital, to estimate its present value.

"Although our startup has met the projected revenue that the investment was based on, the assessing officer wasn't convinced," said Moolayil, who has spent more than $2,300 defending his case and is now appealing against the order.

India has one of the highest tax rates in the world, and the country's tax regime has been criticized by industry bodies for being unfriendly. That has prompted some of the major startups to move their holding companies to countries with lower tax rates, such as Singapore.

Nikunj Bubna, founder of What's Extra India, described the concept of fair market value as vague and meaningless. "Why does the question arise when you have a legal [discounted cash flow] certificate," said Bubna, whose startup helps retail chains run loyalty programs.

Entrepreneurs in India, like those using this Bangalore co-working space, say the “angel tax” has hampered fundraising. (Photo by 101Reporters.com)

"Who decides a startup's fair market value?" he said. "How do you do this for startups when there isn't any cash flow visible yet, when the business model is new or your proof of concept hasn't yet emerged?"

Bubna's company was sent a tax bill in December after he had wrangled with income tax officers in seven meetings over funds raised in 2014.

The tax rule is not new. In 2012, the government introduced an amendment to the Income Tax Act that treats this difference in valuation as income that is subject to 30% tax. Authorities have the right to collect taxes from startups formed after the amendment, and authorities -- as well as some entrepreneurs -- say that the recent sky-high valuations of some new companies have caught their attention.

A Pune-based tax official who handles angel tax cases and did not want to be identified said: "The discounted cash flow methodology needs to be questioned. Cash flow projections of many startups are incredibly high. How can we trust them?"

Indeed, under that tax amendment, startups also have to be able to prove that the money they raised were not funds that were being laundered or they could also face income tax on what the government would class as unaccounted-for wealth.

In the first half of 2017, the angel tax led to a 53% drop in seed funding, according to the National Association of Software and Services Companies. VCC Edge, the data research arm of News Corp., reported a drop in the total number of early-stage deals to 217 in the first half of 2017 compared with 368 in the same period a year earlier.

Industry insiders say 40 to 50 startups have come under tax scrutiny, even those that have folded. But it is only startups funded by angel investors and not venture capital funds or nonresident Indians that have come under the purview of the department.

"These startups are young companies run by young entrepreneurs and if you subject them to such harassment without reason, it sends the wrong message," said V Balakrishnan, an angel investor in Bangalore-based Clonect Solutions, which focuses on enterprise governance, risk management and compliance management. Clonect was also slapped with a tax bill but Balakrishnan said the company was able to convince the tax authority to rescind it.

Moolayil is now trying to rally these startups. In January, he started an online petition asking the government to scrap the tax. There have been recent news reports of the government planning to roll back the tax, but industry players say nothing has been confirmed to them.

Even defunct companies cannot escape the reach of the taxman. Rahul Vats, co-founder of NexGear, a Mumbai-based startup that develops wearable technology devices, said in December that his company was served notice for "improper" valuation. The company has filed an appeal against the order.

"Our company is already defunct. Our app is still on the iOS store but that's it. We haven't dissolved the company, but there are just no employees and almost zero expense as of now," Vats said.

Sharad Sharma, an angel investor and co-founder of think tank Indian Software Products Industry Round Table, suggests the government should use data analysis to unearth fraud rather than needlessly harassing startups.

For now, Balakrishnan of Clonect, formerly chief financial officer at IT consultancy Infosys, said the government has realized that "there is a disconnect in the regulation and they are looking at it seriously." He believes that authorities will resolve the problem soon.

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