Recently, 2700 start-ups were sent Income Tax notices that assert the right of Bharat Sarkar to treat some or all of the capital invested them as income for the company. And hence tax them.
In most accounts - and taxation systems - there is no confusion between income and investment. When an Indigo Airlines makes a profit, it pays income tax. When it issues shares to the public, it uses the cash to build its business, without the tax man claiming a share of that stake sale.
So why this confusion in the case of Start-ups?
Apparently, it’s because many rich Indians have been investing in shell companies at inflated share prices. Not because they were being generous, or foolish, but because they needed to convert ‘white’ money to ‘black’. Such shell companies have a real economic value of close to zero, so if a crore of rupees is invested in such a company, the bulk is returned in cash - after subtracting a processing fee. On the other side, someone ponies up the cash, and gets a cheque, or ‘white’ money, in return.
In response to reports of black-white conversion, the income tax department came up with a rule that allowed its officers to examine the share price of investments in unlisted companies. If they decided that the price was not justified by the underlying value of the business, they could treat it as income in the hands of the receiving company.
This provision is now threatening the eco-system for Indian start-ups. They have been served notices - and in some cases, assessment orders - to pay income tax on investments received 3 years ago. Most have long since spent that money in building their business, the reason for which it was invested; some have already folded up. Few have the cash to pay the tax, which was never part of their business plan. They will either have to sell more shares to pay the taxman, or declare bankruptcy.
Meanwhile, angel investors, such as I, also received love letters from the Income Tax department, asking for a host of details, including paper copies of Income tax returns for the last 3 years. These are documents which the department has long since received, acknowledged, and based on which it has already assessed my tax liability. I found the demand more laughable than painful, but for many other ‘angels’, the paper-work is a huge deterrent to further investment in start-ups.
Giving the tax man the discretion to determine the ‘fair’ value of a start-up is fundamentally flawed. A start-up is little more than a dream or an idea. As an angel, I put my money where I see an opportunity in the market, a gleam in the founder’s eye, and a hunger in his belly. The value put on the company is set by dialogue between angel and founder, not by some canned accounting formula. Discounted cash flow statements are drawn up to retro-fit this pricing, but I don’t know an angel who ever looks at them.
Now taxmen are trampling over ground where angels scarcely tread.
Many influential bodies have tried to get the government to eliminate the “Angel Tax”. Instead, what we have in response is a drive towards more bureaucracy. Start-ups now need to empanel themselves with the Department of Industrial Policy and Promotion (DIPP), with the vague promise that this might spare them the angel tax. Investors need to have 50 lakhs of declared income and a net worth of 2 crore to qualify as angels. Many friends and family, who are often the first angels, won’t qualify. Nor will retired people with low income, but high net-worth, and lots of valuable business experience to contribute.
I have several comments on this state of affairs:
First, when two consenting adults agree on the value of a transaction, that is the only ‘fair’ price. Grasping this is essential to economic freedom.
Second, the government has to decide whether investment is income, or not. If it is - and this would redefine global commercial practice - then all public share offerings should be taxed.
Third, giving discretionary powers to bureaucrats is highly destructive. If they possessed discrimination, they would be able to distinguish between shell companies and start-ups.
Fourth, there is no consonance between the empty rhetoric of Modi’s “Start-up India”, and the government he runs on the ground.
Fifth, in India, the bad drives out of the good, aided by the government.
Sixth, every mis-step by the government creates more government, less governance.