Understanding Death By Angel Tax

Last week, the Indian Tax authorities sent out multiple tax notices, spooking startup founders for the pejoratively termed “angel tax”.

Starting up, and investing in young companies, involve a lot of uncertainty. When one starts out, there is very little visibility on the future. Customers are few in number, the team is small and capital is usually limited. Founders, quite literally, live day to day. Even a small loss in customers, capital or team can break a business. This is inherently why startups are so risky, and need all the support they need.

Especially from giant, rule-making entities like the government.

The new Indian government made all the right noises after coming in 2014. Under the Department of Industrial Policy and Promotion, an ambitious program called “Startup India” was started. The goal was to make India a startup hub, an INR 10,000 Cr ($1.4Bn) pool was pledged, freedom from capital gains tax for 3 years was committed, and startups were promised that “we unobstacle“.

Great marketing, but would the product follow?

By 2018, Startup India has seen just 90 Cr actually disbursed, with 600 Crcommitted. That is an extremely small percentage of the promised amount. What about the red tape and lack of bureacracy? Most founders found no positive impact via the program. But the biggest question remained on how the government would tax startups.

One may wonder how a loss-making, cash-constrained startup could even run any tax. We read multiple stories on startups continuing to make losses, and needing to raise money. Young companies need money to even payout salaries and grow, and most remain unprofitable for years. 

What could you tax, really? 

The trouble with the Indian ecosystem is that while there are numerous legitimate startups, there are various tax evasion techniques that utilize newly formed companies (or “shells“). In 2012, the Indian government created a tax clause to prevent money laundering through such channels via “share issues”. Under Section 56 (ii), share issues can be taxed at a 30.7% tax rate, if the “value of shares” is higher than the “fair market value” (note these keywords). Entities exempt from this tax are venture capital firms and foreign investors. 

Who aren’t exempt? Angel investors, and hence the name “angel tax”.

While the positive intent of the government was as fresh as 2016, the law they are now invoking pre-dates them. The mechanics of how this taxation works is intriguing, and revolve around the keywords I referred to above. If the “value of shares” is higher than the “fair market value”, the entity which issues shares is taxed. Let’s say the company raises $300K from an angel at a $1MM valuation. Let’s say the fair market value is $300K, the difference of $700K could result in $200K (30%) of tax. Does that imply that out of your $300K raised, $200K goes to tax?

That is, incredibly, absolutely right. 

Let’s rewind. The startup likely makes no profits and has no positive cash flow. The founders, after incredible effort, have raised money. The government promised to take care of startups, so the outcome of all this effort is a tax? That is exactly what multiple founders have faced. The follow-up question is then if the investor defines the company valuation, who/what determines fair market value? 

Income tax officials. Really.

Before we get into why this structure has all the wrong incentives, let’s try to understand how fair market value is really determined. By the law, startup founders need to get this value from an authorized merchant banker. The valuation is determined using discounted cash flows.

This sounds correct theoretically but shows a lack of understanding of how startups operate, or are valued. Firstly, it will be a long time before startups start generating any cash. Secondly, it’s incredibly hard to predict cash flows. Due to the first, some officials may argue the valuation of the company is negative. Due to the second, valuation can vary considerably. 

Startups are effectively getting taxed on an impractical, moving yardstick. 

From my experience with valuation, it is an incredibly complex subject for early-stage companies. Multiple factors exist and are not limited to market size, model, team, traction, exitability. With the lack of any data, discounted cash flow is almost never the method utilized. When a deal closes, the valuation is, most critically, a negotiation and may not finally have a true “scientific method”. The key point to note is that investors put their money (capital) where the mouth is (valuation), and that brings me back to wrong incentives. 

A tax/law official, who has no interest in the future of the company, is potentially interested in taxing the company. If the fair market value is in the “control” of the official, the official is incentivized to modify (i.e. reduce) fair market value. This could potentially result in behaviour that is detrimental to the startup, involving multiple visits to appease the taxman. Case in point is where the taxmen say “DIPP approved startups may be exempt”, clearly indicating the vagueness associated with even government approved startups.

For a startup founder stretched on time and resources, this could be deadly. In case the founder is actually hit with a tax bill, the company will likely never be able to service it.

Death by Angel Tax is not hypothetical, but real.

Most other countries have angel friendly incentives, while this could dissuade an already diminishing angel investor base. Angel investors take the highest amount of risk. For a company that needs to be backed at a pre-product, early revenue stage, hurting angel investing could considerably impact innovation. For all the late stage activity, we need startups to start before they get to that stage.

Startups need Angels, and not ill-devised tax shackles that could drag them to death.