StartupTax

SEBI Finalizes Angel Fund Regulations

No Comments » Written on September 17th, 2013 by
Categories: Startups, StartupTax

SEBI has notified final regulations for angel funds. I have noted many of these in the past, so for background:

In brief, angel funds are now only allowed as an “Alternative Investment Fund” which requires registration.

  • Angel funds must pay Rs. 200,000 to register.
  • Such funds can raise funds of at least 25 lakh (2.5 million) per investor, and a minimum corpus of Rs. 10 crores. (100 million)
  • Can you be an angel investor? As an individual, you need to have a 20 million or 2 crore “tangible” networth apart from your primary residence.
  • Also you need to either have had startup investment experience, have been a founder of more than one startup or have 10 years of experience as a senior management executive.
  • Or if you’re a company, you must have a Rs. 10 crore (100 million) net worth.
  • Angel funds cant invest in companies where control or management is with relatives of ANY angel investor. Relatives means [children, grandchildren , brothers, sisters] (and their spouses), or parents. Oh, and such people can’t be directors of any invested company either (before the investment) and cannot own more than 15% of equity.
  • Funds must be raised within three years.
  • Investments in any company must range from 50 lakh to 5 crores.
  • And money is locked in for three years. This is strange but obviously overridable in case of an acquisition. (Come on, SEBI is not a dolt, they will grant permission in case that happens)
  • You can’t have more than 49 investors in an angel fund.

Basically, the small investor is out of the ambit of these rules. Does that mean the small investor can’t invest? Of course he can!

Just get a convertible debt deal if you’re worried about startup tax. Or if you’re the real risk taking kind, at the small level (sub 50 lakh), don’t even bother about startup tax.

Angel Fund Guidelines: Helps the Superangels, Keeps Out Smaller Investors

No Comments » Written on June 26th, 2013 by
Categories: SEBI, Startups, StartupTax

SEBI has introduced new guidelines for Angel Funds. As I’ve said recently, this is an absolutely important requirement in order for startups to avoid the “Startup Tax” (, a tax regulation that classifies investment as “income” if it is at a premium to the “par” value of a share of a company.

(Read the free Startup Tax e-Book)

The tax laws allow angel funds to skirt this rule, but what an angel fund actually means was left to SEBI. And this is what SEBI has said, in simple terms:

Angel funds a sub-category of SEBI AIF Cat-1, Like Venture Capital Funds with Only 25 Lakh Minimums

The SEBI Alternative Investment Fund (AIF) regulation is what allows pools of capital to be used in India to invest in anything. AIFs include Venture Capital Funds (VCFs) as a Category 1 player. An Angel fund will be a sub-category under the definition of VCFs. This sounds complicated, but we’ll get to that.

Other AIF investors, including those in VCFs, need to put in at least Rs. 1 crore (10 million) each.

But for Angel funds, the requirement per investor is only Rs. 25 lakh. (2.5 million) This amount can be amortized over three years, so the investor can spread the money over a period.

My view: AIF Cat-1 regulations are a pain. You can’t get new investors once you’ve launched a fund. (Close-ended) Risk and portfolio reporting requirements are detailed, with items like foreign exchange risk, detailed valuation methodology etc. Investments must be “revalued” every six months. There needs to be an office and detailed record keeping, that SEBI can inspect on demand.

However, there’s no other alternative, so the regulatory cost must be paid.

Angel Investors Must Meet Criteria for the Badge

Want to be an angel investor? You gotta have

  • Early stage investment experience, or
  • Been a serial entrepreneur, or
  • Had 10 years experience as a senior management executive

and

  • Have Rs. 2 crore (20 million, or $350,000 ) in tangible assets.
  • Companies that want to become Angel investors would need Rs. 10 cr. (100 million) net worth

My View: The entry criteria would have qualified me (I’m a serial entrepreneur) but I don’t have the Rs. 2 crore tangible net worth. That means I can’t be an investor in an angel fund, which makes total sense: The Rs. 25 lakh minimum, with a net worth of less than Rs. 2 crore, is probably a good idea.

If people like me want to invest in a company and can’t meet the above criteria, they should just go in on their own and not create a SEBI regulated AIF entity called a venture fund. Yes, the tax issue can be skirted – if you invest using a convertible debt instrument, it’s just a loan convertible to debt later at a certain valuation.

If you co-invest along with an “Angel Fund” at the same valuation but an amount less than 25 lakhs, you can quite easily prove to income tax authorities why the “premium” was justified – after all, a SEBI registered AIF Category 1 fund did the valuation, and they know best. Income tax problems solved.

Angel Funds Need Minimum Rs. 10 crore

Oh yes. You need Rs. 10 crore (100 million) in “corpus”. At the minimum, you need 40 investors with the 25 lakh commitment each. (Regular AIFs need 20 crore)

My view: This might sound like a big deal, but it’s not. Remember, like I’ve said in the last point, you don’t need to be an investor in an angel fund to actually do angel investments. If you do, and you qualify, it’s not such a bad idea to get a corpus of $2 million (Rs. 10 crore) together.

The Angel Fund “Manager” Must have 2.5% Skin In The Game, or 50 lakh

In the spirit of AIF regulations, all managers need to have their skin in the game, meaning they own a part of the fund. For regular AIFs the limit is Rs. 5 crore (50 million) or 2.5%, whichever is lower.

However, for angel funds, the manager needs to invest Rs. 50 lakh (5 million) or 2.5%, whichever is lower.

My view: It’s very important to have skin in the game. You lose when the fund loses. There’s no greater motivation to succeed. However, for people who don’t have enough money to invest, but can manage a fund, this is a fairly hard barrier.

Restrictions on Angel Investment

To avoid the abuse of angel investment as a vehicle to give bribes or avoid taxes, there are some specific rules that invested companies need to meet:

  • Indian incorporation, and less than 3 years old
  • Have a turnover of less than Rs. 25 crores
  • Are not listed
  • Have no relation to any industrial group whose turnover is 300 cr. or more
  • Has no family in the Angel fund

My View: It’s very unlikely that an early stage company wouldn’t meet this criteria. The industrial group connection and family issue are to prevent abuse.

The family regulation is funny. Venture Capital funds can invest in their own family-own companies!

Each Invested Company Must Get 0.5 to 5 Crore, Locked in for 3 years

Angel funds have to buy in at least Rs. 50 lakh (5 million) and a maximum of Rs. 5 crore (50 million) of any company.

They also have to stay invested for at least 3 years.

My View: Nothing less than Rs. 50 lakh? On principle, I think that’s a good restriction. Companies need more money than that nowadays, and this is an organized fund, honestly, so most investments would meet this criteria anyhow. If someone really wants lesser the deal can be to invest Rs. 50 lakh in multiple “tranches” based on some forward looking milestones that need to be met.

Nothing more than 5 crore? That’s strangely limiting when an investor needs to continue to invest in subsequent rounds to maintain its shareholding percentage. This amount could exceed the 5 crore required

The Three year lock-in is also strange. The waterfall model of investment means an early investor will be bought out by a subsequent investor (a VC fund or such), who might want to deploy more money than the company needs. In which case, it needs to offer existing investors a partial or complete exit.

What About the Fees?

Currently AIFs have heavy fees.

  • Rs. 100,000 to apply
  • Rs. 500,000 to register
  • Rs. 100,000 per individual fund.

There’s no indication of whether these will be relaxed for Angel funds. These fees are difficult to justify at an angel level of investment.

The Judgement: Startup Tax Is Still A Problem

I think the regulations allow a wannabe-VC-fund to now invest in companies. But it’s just a mini-venture-capital-fund, and not really something that serves the purpose for angel investment.

When I complained about the “Startup Tax”, it was about a specific use-case that is probably the most common in early startups. When a company gets early stage investment by angel investors, at a valuation that is a premium because that’s how the market works, it will have to pay tax if it can’t justify the premium.

The tax department said they’d solve it by allowing SEBI to define what an “angel” means, to keep them out of that regulation. (The regulation was created because politically connected companies were being invested into, by corporates, at a massive premium, and there was no taxability involved)

SEBI has now defined Angels as rich investors who pool in capital, but aren’t rich enough to be venture capital investors. Essentially what SEBI is saying is that if you want to invest in an early stage startup, you have to find a fund that has gone through the SEBI hoopla, invest in it, and convince that fund’s manager that the “pool” needs to invest in that company.

This might not fly with many of the angels that currently invest, and they might still go their own way directly investing, even if it means dealing with the Startup Tax issue.

However, nowadays there is more interest in “superangels”. Funds that buy stakes in 500 companies. Funds that have a lot of money and spread it around. Funds that invest in the whole ecosystem, including incubating companies. Funds where money is collected from investors, pooled and invested by managers. For them, this regulation is a brilliant deal, but with a little more money they could register as venture capital AIFs in the first place.

Speculation: SEBI Angel Fund Rules Could Help Ease Startup Tax

No Comments » Written on June 20th, 2013 by
Categories: SEBI, StartupTax

The Finance Minister had in his budget speech mentioned that:

SEBI will prescribe requirements for angel investor pools by which they can be registered as Category 1 AIF venture capital funds.

(Read: Startups in Budget 2013, a Mixed Bag)

CNBC has the news that SEBI might announce the requirements on July 25 (speculation):

In an exclusive to CNBC-TV18, sources say the Sebi board may announce rules for angel funds on June 25. Some of these rules may include angel fund investment to be limited to Rs 50 lakh- Rs 5 crore; angel funds to be invested in a company for at least three years; angel investors to invest in companies not older than three years; investee company to be unlisted and with a maximum turnover of Rs 25 crore; the investee company may not be related to a group with a revenue of greater than Rs 300 crore.

Sources add that the Sebi may also stipulate that the fund must not have any family connection with the investee company and that no angel fund scheme may have more than 49 investors.

Note: Cat 1 AIFs already have three sub-categories:

  • Venture Capital Funds
  • Social Funds
  • SME Funds

The Angel fund will have to be a separate sub-category.

Welcome, Tax-Pass Through

Note that AIF regulations means Category 1 funds, VC Sub-Category get a tax pass through, that is, any income made by fund investors will be their income, not that of the fund, which is beneficial for entities based in mauritius or singapore, who don’t pay any capital gains taxes. Cat-1 AIFs had certain restrictions, like Rs. 1 crore per investor,  which might be relaxed.

While this is a useful thing, it’s no different from the angel investing directly, which is what currently happens. 

An angel fund can help in the sense that it allows people to pool in cash and invest as one entity (for instance, 10 investors in one company can get a single represenation) but with the tax pass through each investor gets the tax benefits that he normally would if he invested on his own.

Fixing the Startup Tax, Somewhat

However some of the rules are designed to help avoid the Startup Tax problem. (Read the free Startup Tax e-Book) Angel investments in companies at a “premium” have been classified as “income” rather than an investment, unless the startup can explain to the tax authorities how such a premium is justified.

This has been brought in because it seems politicians are being bribed by corporates using the investment route. The corporate would invest a large sum of money into a small company owned by a politician, and take a very tiny stake in return. This is effectively a bribe since the money is not expected to be returned (no equity investment is), and the company will pay no tax on the investment (since it’s a capital flow, not income). See the Jagan-Srinivasan enquiry, or the Dasari Rao-Naveen Jindal allegations.

The tax authorities have plugged this loophole. A large investment at a premium will be called income unless the premium is justifiable, and if it’s income, the money will be taxed. In the process they make it very inconvenient for small startups who need capital and much of their value is based on future prospects not easily quantifiable.

In Budget 2012, the above problem was partially addressed; if a SEBI regulated AIF invested in a startup, it wouldn’t get hit with this Startup Tax. But the SEBI AIF rules made it difficult for small angels to start a fund – each fund needs at least 1 crore rupees per investor.

The above rules, I think, are designed to thwart the creation of entities by corporates to, again, bribe politicians. (If rules are lax, a corporate will create an AIF and then pay big money to a startup?) The AIF rules are already stringent – not more than 25% in one entity, minimum lock in, and so on. These rules can further contain the abuse.

The rule that the “group” of the company invested in should not have a turnover of Rs. 300 cr. or more, and there should be no family connection between the fund and the company; this help prevent one layer of abuse. And then, limiting the angel investment to Rs. 5 crore creates less chances of bribes (which would mostly exceed that amount by a multiple of 10).

AIFs currently can have upto 1,000 investors, but the limiting to 49 for angel funds is peculiar. However, the logic may still be related to abuse, to avoid the creation of a pool like Sahara or such.

Still Not Enough

Till the regulations come out, we’re not sure what will happen but many regulations need to be relaxed. For instance, one AIF regulation is that a fund should have a “key person” who has five years of experience in fund management with a professional qualification etc. Angels are typically not this profile, and this requirement must be relaxed.

The current requirement of Rs. 1 crore per investor is sure to be relaxed, but how much? I believe it should be taken down to Rs. 10 lakh, but I doubt that will happen – it is likely to be Rs. 50 lakh or something. Knowing how much angels pool in (5-10 lakhs each, typically) a large minimum would restrict their ability to create an AIF fund together.

June 25 will tell us more. CNBC’s sources haven’t always been accurate so the end-result may be quite different.

Startups In Budget 2013, A Mixed Bag

1 Comment » Written on March 1st, 2013 by
Categories: Budget2013, Startups, StartupTax

What’s in it for startups? Last year, we had a horrible section (Read the full e-book) that still works against angel investors in early stage startups. (Angel investments would be taxed if they couldn’t prove that an investment had a sound valuation backing it – and early stage startups are wet-finger-in-the-air valuations)

The Return of the Rs. 1 Crore Angel, Or Something

In Budget 2013, there are some interesting changes. First, to solve the above problem in last year’s budget, this year the FM said that:

SEBI will prescribe requirements for angel investor pools by which they can be registered as Category 1 AIG venture capital funds.

This can be good or bad. Good because if AIFs are effectively governed like VCs, their investments don’t hit the wall that my last year’s rant was about.

Bad because of multiple factors:

  • Much higher regulation and transparency that is currently required of AIF kinds of funds.
  • The current minimum any investor can put in is Rs. 1 crore. Angels in India don’t really seem to have that kind of money to spare. (other than the big organized ones)
  • Involving SEBI can mean a lot of paperwork (reporting).

Let’s hope that SEBI creates less of a reporting and investing nightmare when it defines what constitutes angel investor pools.

“Pass Through” Status Good For Angel Investors

A company or trust registered as a VC fund or angel fund as above has to pay tax on investments when it generates profits. But the profits are really those of the investors in a fund,and different kinds of investors may have different tax structures. An investor through Mauritius may not have to pay capital gains taxes, but the vehicle – the VC fund – will have to. Another investor may have losses in his books, but he can’t offset them against the gains made by the VC/angel fund because they are in different entities.

In the budget, Category 1 AIF Funds (VC funds) have been given a pass-through status. Meaning, the gains made by the fund are passed through to the investors (in the proportion of their holding). This can help substantially, especially when raising money from foreign shores, where tax structures play an important role.

Maybe Flipkart can Flip The FDI Probe Over

Pratyush brought this up. The only reason Flipkart’s getting grief about FDI in multi-brand retail is that its main investors (Accel and Tiger) are foreign owned. So they have to do a two-company structure, where Accel and Tiger own stakes in a wholesale company, which sells to a retail company that owns the website and handles delivery.

Why are Accel and Tiger foreign companies? Probably because Mauritius has no cap-gains taxes. If they created a VC firm in India, then Indian taxes would apply to any gains, and that’s no good. Now, with the tax-pass-through structure, would it be better for Accel and Tiger to set up an Indian Venture Fund, make it a class 1 AIF with SEBI, and use the tax-pass-through? And then, as an Indian entity, the AIF entity should have no problem owning stake in Flipkart’s retail site.

However, I’m not a lawyer, so I don’t know if the AIF, even if set up as such, would still be a “foreign” investor due to it’s eventual ownership.

SME factoring credit guarantees to SIDBI

SMEs that serve large enterprises might need cash flow before payments flow in (due to long gestation time before payments). Factoring allows banks or institutions to provide cash flow support to an MSME against receivables; and an act has been passed to allow factoring, in 2012 January. SIDBI can act as a credit guarantor for SME factoring, for which the budget has given it Rs. 500 cr.

Additionally, SIDBI’s refinancing facility for SMEs (that is, they take on part of the risk of SME loans made by other financial institutions) is now enhanced to Rs. 10,000 cr. (from last year’s 5,000 cr.). SIDBI even has a website for this.

MSME benefits to continue upto three years after

Micro, Small and Medium Enterprises (MSMEs) may get the MSME ministry to pay for participating in international fairs, or for credit guarantees (mentioned earlier), or for other such schemes that are not tax related.

The budget has proposed that if an MSME should move into a larger bracket and lose the MSME status, it can continue with the above benefits for the next three years.

Incubators for CSR

Funds provided to incubators within colleges and approved by some ministries will now qualify under the Corporate Social Responsibility (CSR) utilization that all companies need to spend on, with at least 2% of their net profits. This is great if you are an incubator inside an institution, but you really need to be going out there, really gung-ho, trying to get funds allocated before the next “insti” starts its round.

SMEs can list without IPO with informed investors

There are now pure SME exchanges with less onerous listing requirements. While they created the tool, they must have squealed in delight. Listing though, has been way too ineffective, with complex listing requirements needed even now. This can be fixed, but the exchange will have to find the traders.

However for new issues , you can list your SME in this exchange, and if you don’t want to do a full open offer, do an offer to “informed investors”.

Unlisted Buy-Backs Get Taxed

Private limited companies might resort to buy-back agreements to offer their investors liquidity. An abuse of this is to use the buyback route to provide money to investors; if the companies buy back at a low enough price, then shareholders can get money in their pockets and pay a very low tax (as capital gains). This has been blocked by the budget, stating that all unlisted company buybacks must pay 20% on the money.

This is scary and throwing the baby out with the bathwater. Buy-backs serve a useful clause as well – to provide liquidity or partial exits to investors, However, there is hope. I can recommend that you set up your company as an LLP where buy-backs of this sort are not at all necessary, since distribution and withdrawal are quite simple (no dividend distribution tax).

Startups and SMEs should learn to accept debt as a part of life and go apply for some of the ventures, even for small ticket loans where the government stands guaranteed. Money can vanish fast so don’t splurge.

What have I missed?

Jagan-Srinivasan Enquiry Explains the Startup Tax

1 Comment » Written on June 9th, 2012 by
Categories: StartupTax

When the CBI investigated BCCI Chief N. Srinivasan’s company, India Cements, they seem to have uncovered why the “Startup Tax” was introduced in the budget. (Read Full Set of Posts) The company invested in companies owned by Jagan Reddy, son of the late YS Rajasekhara Reddy, who was the Chief Minister of Andhra Pradesh, in a way that the CBI says was a disguised bribe. From Firstpost:

According to the FIR, India Cements made following investments in Jagan Reddy’s Companies:

- Rs 5 crore in Carmel Asia Holding Pvt Ltd, one of the 36 companies created by Jagan Mohan Reddy. He paid Rs 252 per share, while the promoters and group companies had paid only Rs 10 per share.

- Rs 15 crore in Raghuram Cements Ltd (now called Bharathi Cements) purchasing 12,50,000 shares at a premium of Rs 110 in 2007.

- Rs 40 crore in Jagathi Publications, which owns Sakshi TV and newspapers.

And in return, according to the FIR, Jagan Reddy’s father YSR Reddy rewarded Srinivasan’s India Cements with the renewal of a land lease in Kadapa district on 11 July 2008. Srinivasan’s cement company was permitted to draw upto 10 lakh gallons of water from Krishna river by a government order on 22 July 2008 and 13 million cubic feet of water from Kagna river through a government order on 12 September 2009.

“It is alleged that the promoters and group companies of Jagan Mohan Reddy had subscribed to the capital at par whereas all other shareholders had subscribed to the shares at a premium of Rs 252 per share in Carmel Asia Holdings as an alleged quid pro quo for the benefits which they got from the Andhra government,’’ the FIR says.

From MoneyLife:

Nimmagadda Prasad alias Matrix Prasad, touted as entrepreneur with a golden touch in the pharma industry, is also alleged to have followed the YSR/Jagan model of investing in their companies in return for getting access to various resources. Prasad has been charged with investingRs100 crore in Jagati Publications that publishes Sakshi Telugu daily, besides putting in another Rs244 crore in Bharati Cements and Rs200 crore in Carmel Asia, all floated allegedly by Jagan.

In return, Jagan's father, late YS Rajasekhara Reddy, allegedly allotted 15,000 acres of land in Prakasam and Guntur districts to Matrix Enport, the company owned by Prasad, for development of the Vadarevu-Nizampatnam Port and Industrial Corridor. Till date the project, initiated in 2007, has not made any progress.

This is important because this is why they decided to have an investor “explain” when he invests at a “premium” into a company. But why didn’t Jagan’s company just bill Mr. India Cements for some random service like “consulting”?

Because a service attracts service tax. Selling a product attracts VAT. And then, the receiving company has to pay income tax on the money it gets. The bribe taker would have to pay, for Rs. 100 received:

a) Rs. 10-12 in service tax

b) 30% of the remaining as income tax (since it’s a bribe they won’t even spend it)

The other method of taking it as investment instead is far more “tax effective”, with India Cements buying a tiny stake for a large sum. It’s not a service, so no service tax. There’s no income to the company – only an investment. So no income tax.

This is why they have created the new tax structure, which as a by-product kills all other legit startups as well.

I recall that I had been told this: even Reliance Infra had purchased shares into Reliance Power at a premium, while the promoter had bought shares at a far lower value a few months earlier.

The current solution – of limiting such investments to Rs. 5 crore - will not help much. The Jagan types will simply float more companies instead. But at least it will be noticed that a large entity is investing exactly 5 cr. in a big number of tiny shell companies, and then justice can happen.

What we need is a law that helps catch the Jagan types but still allow startups the ability to raise money from non-VC investors. But in the light of the massive fraud in the Jagan-Srinivasan case, we might not get an easy way out.

What to do then? Simple: don’t take money as equity. Take money as convertible debt instead. Debt reflects on company books and is likely to be questioned easily in cases like Jagan’s companies, while genuine investments are explained easily. And when the time comes to convert, you can convert it and then be able to explain that time’s valuation better.

(Note: This is not to justify the startup tax, but to state that if we want to repeal it, we need to address abuse cases like the case above.)

Startup Tax: Diluted To Allow "Angels"?

No Comments » Written on May 7th, 2012 by
Categories: Budget2012, StartupTax

The FM, in his remarks while introducing the Finance Bill today, provided some relief to the startup community by potentially allowing angel investments to not attract the Startup tax.

(For More: Read the E-Book, and all posts)

It has been proposed in the Finance Bill that any consideration received by a closely held
company in excess of the fair market value  of its shares would be taxable.  Considering the
concerns raised by "angel" investors who invest in start-up companies, I propose to provide an enabling provision in the Income Tax Act for exemption to a notified class of investors

Let's not rejoice too early. We don't know what the enabling provision is, just  yet. I will post when I find out (and please, do let me know if you do!).

An angel investor isn't a specified class anywhere in any act. The only specific kinds of investor entities are a) Venture Capital Funds or b) Private Equity Funds. Other forms include large institutions like Mutual Funds, Insurers, Pension Funds etc. The concept of an "Angel" is just an individual that invests in a company at the early stage. So I would expect the definition to include equity fund infusions into companies, by individuals, below a threshold limit (say Rs. 10 crore).

Of course, this does create other problems, like what about private equity funds or insurers or other investors investing large sums of money into companies. (Nowadays, e-commerce shops easily raise $15 million) But there are proper venture funds investing here, and these are exempt from the Startup Tax implications.

But this is great news in that the Startup Community has managed to get the FM's ear. Some people have told me I was the first to break this news, and that makes me feel good. What matters, though, is that this has found the ears of the powers that be, and I hope this issue gets resolved soon.

FREE E-Book: The Startup Tax in India

1 Comment » Written on March 27th, 2012 by
Categories: StartupTax

I consolidated material from all the posts on the Startup Tax in India and put it into an easy-to-download E-Book (PDF). I hope you like it!

StartupTaxBig

As things change, I will update the E-Book.

FAQ on the Startup Tax

1 Comment » Written on March 21st, 2012 by
Categories: Budget2012, StartupTax

Lots of questions have come in on the Startup tax post (Angel Investors Beware: Funding Startups Could be Classified as Income) and I’ve tried to address them here. The idea, for those who don’t have the time, is that investments in any company must now be “justified” to a tax officer, unless they are by a VC fund. If the tax officer finds that the money was more than “fair market value” using a set of criteria that are irrelevant to most tech startups today (valuing physical assets etc.), then whatever is extra will be recognised as “income” on the startup’s books, meaning they have to pay tax on it.

It’s Only Active In 2013-14!

The clause applies to “Assessment Year" 2013-14. In that year, you file taxes for 2012-13. It’s one of those strange budget things, but when they say assessment year they mean it applies to the year preceding it.

See the memorandum and search for Section 56, this clause is at the end:

This amendment will take effect from 1st April, 2013 and will, accordingly, apply in relation to the assessment year 2013-14 and subsequent assessment years.

The Clause applies to investment from a “Person”. Angels can create a company and invest.

Under Section 2 of the IT Act (“Definitions”) :

“person” includes—

(i) an individual,

(ii) a Hindu undivided family,

(iii) a company,

(iv) a firm,

(v) an association of persons or a body of individuals, whether incorporated or not,

(vi) a local authority, and

(vii) every artificial juridical person, not falling within any of the preceding sub-clauses.

The last entry could even include an LLP (which is currently not listed specifically). But effectively this blocks any form of angel investment whether directly or through an investment vehicle (other than a VC fund, of course).

Startups Will Spend All That Money, So No Profit To Pay Tax On!

If a startup gets investment it will use most of it up in the year. Even if the tax department classifies the money as income, it will be offset with the expenses thus, no tax will apply.

Two points to note here. First, these “loss” that startups incur in the first few years are offset by profits in subsequent years (losses are “carried forward”). This is a tax element that is legitimate; so if you make a profit in subsequent years, you don’t have to pay the government any tax until you’ve covered up your earlier losses. Effectively, by treating investment as income, the startup tax will eat into future profits. (Loosely speaking, losses carried forward are an “asset”) Either you will pay the tax todaa, or tomorrow; it’s a tax all the same.

Second, note that not all expenses are written off in the first year. Yes, some are, like salaries. But if you buy assets – tables, chairs, a UPS, equipment, machinery and such – these are “depreciated” over time (a different time for each kind of asset).

In a simple scenario where you get Rs. 10 lakhs and use it to invest in equipment with a depreciation rate of 10% a year, the total ‘expense’ in the first year is Rs. 1 lakh. If the investment is treated as income, you have 10 lakhs of income with 1 lakh expense; so your “profit” is Rs. 9 lakhs, on which tax applies. (Remember, at this point you don’t even have money as you used all that 10 lakhs to buy equipment)

But This Will Curb Black Money?

If anyone is aware of the system of black money, it is the tax department. Black money is either money on which you don’t pay tax, or money obtained through corruption. (or both) If an investor legitimately invests in a company, using a cheque from a bank account, is the “black” money the fact that his money is tainted? In which case, use the “Section 68 amendment” to explain the investor’s sources instead; this fair-market-value clause is unnecessary. (Read: Private Cos: Investors Must Reveal Source Of Funds)

The other thing is that this clause does not apply if your investor is a non-resident. Most people know how easy it is to route money abroad and then bring it back as “investment”; if that is all it takes, how can it prevent black money?

Can’t Startups or Angels go Abroad?

Not every investor can, and it’s expensive, through it seems the Singapore route may not be. However, do we really want to be telling our startups that we can’t invest in them unless we go abroad? And what’s to stop the tax department from easily including foreign investment in the clause?

Going abroad has other ramifications. Wealth held abroad is subject to wealth tax. From this budget, you have to report in more detail on your holdings abroad; if they find out you’ve created a company abroad to invest in Indian companies, will they just ignore it? The General Anti Avoidance Rules (GAAR) will likely be used to squeeze the life out of the investor.

Startups going abroad is more painful. You hire here, you work here, you know the market here. How do you service that market from abroad? If you sell locally, you need local presence. While some companies will be able to go abroad, create an entity, and then come back create an Indian subsidiary, this avenue is fraught with risk and expense.

I hate to think of “going abroad” as a solution. In the 90s, I refused because I wanted to start a company. In the 2010’s I should go abroad if I want to start a company? Jeez.

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If you have more questions, please comment here. I’ll update this page.

Ramadorai, Ex-TCS-CEO, Will Advise Govt On Startup Tax

No Comments » Written on March 21st, 2012 by
Categories: Budget2012, StartupTax

The Startup Tax situation has elicited serious response. Pluggd.in has reported that the Ex-CEO of TCS, S. Ramadorai, has been asked to advise the government on the issue.

Indian government has asked S. Ramadorai, ex-CEO of TCS to advise the government on startup tax bill. S Ramadorai currently serves as an advisor to the Prime Minister of India in the National Council on Skill Development, Government of India. He holds a rank equivalent to an Indian Cabinet Minister.

More from ET: FinMin says New Safeguards For Angel Investors

The finance ministry has said it could bring in more safeguards in the income-tax law to ensure that genuine angel investors are not impacted by a budget proposal to tax exorbitant profits by venture capital funds, but effectively ruled out a rollback.

The use-case that the government is looking to plug is where a large sum of money comes in from an Indian resident into a company, which classifies it as “share premium”. This money has no service tax, and the company pays no income tax on it. The “investor” may get a few shares at a very high rate (say Rs. 1 crore per share). The company gets to use that money for regular expenses, and never pays any tax.

How would the government differentiate that situation from, say, a situation where an angel or seed level investor buys into a startup, and pays a premium because the founders bring in knowledge or experience or connections or passion?

It’s going to be tricky but I imagine what will eventually happen : The tax department will only demand an explanation for investment above, say, Rs. 3 crores per year.

What do you think?

The current workarounds for angel investors are:

a) Go abroad. The tax rule applies only to investments from Indian residents.

b) Use convertible debt, where the investor doesn’t buy equity shares but uses some sort of convertible instrument issued at par, where the convertible ratio may be either deferred (decided later) or pre-decided.

c) Invest in your stake at par, provide the rest of the money as a loan. This has structural issues with new investors coming in, for legit startups.

d) Create the startup as an LLP instead. This has no concept of “shares”.

The tax-evaders can use these routes as well, remember. It’s going to be very difficult to design a system that keeps out only wrong-doers but allows the large majority of valid investments.