India has a particularly stupid piece of tax law popularly known as the “Angel Tax”. When a private company goes to raise money it means that the capital inflow is taxed as income at a rate of 30.9%. This is not just economic illiteracy it’s idiocy.
To take an example:
TravelKhana, an award-winning start-up, riding high on profits and bullish on expansion till last December, is now wondering whether it will exist in the next six months. The Noida-based start-up, a pioneer in delivering food to passengers travelling by train, was slapped with an ‘angel tax’ order of Rs 2.30 crore on 21 December. On 5 February, the Central Board of Direct Taxes (CBDT) froze the company’s four company accounts and withdrew the entire sum of Rs 33 lakh from them. After desperate pleas by company founder Pushpinder Singh, CBDT un-froze the accounts but has left them penniless. Stung by this unprecedented behaviour, Singh is now questioning the company’s survival.
Successful start up needs more capital and government then near bankrupts it by nicking all the money in tax? Yes, idiocy:
Closely-held private companies receive equity funds from outsiders. When these investments are made at a premium to the fair price, tax laws have so far held that the amount raised in excess to the fair value is taxable. The amount is reckoned as “income from other sources” and taxed under Section 56 (ii) of the Income Tax Act. The rate of tax was a hefty 30.9 per cent. This was applied not just to mature private companies, but also to small startups that took early-stage investments from residents in India.
Fair price? But how are we to determine what is the fair price? Other than what people are willing to pay for something of course? Well, that’s where we meet the Licence Raj and the Indian Babu:
They were particularly concerned over the tax evaluation process, alleging that in many cases, the assessing officers disregard the discounted cash flow (DCF) method-based valuation report (as prescribed by law) and, instead, recalculate the valuation via the book-value method. The latter takes into account only the firm’s physical assets, which is unsuitable for technology startups with asset-light businesses.
That’s not just unsuitable that’s insane. The value of a start up is in the dreams and abilities of the entrepreneurs, something that doesn’t appear in a book valuation.
Still, the Modi government tried to make this less bad but did so in a bad way:
The government in India has made it easier for startups to claim tax exemptions on funding from angel investors. The reform was prompted after startups received notices from the tax department on their angel funding last year. Media reports citing government data said that only four percent of applicants were able to obtain the exemption in the first two and half years of its availability. According to the new rules, startups can directly apply for the tax exemption through the Department of Industrial Policy and Promotion (DIPP). The Central Board of Direct Taxes (CBDT) will then review the application within 45 days. The application itself has also been simplified. Applicants may use a Form-2, along with other required documents, to obtain exemptions on shares already issued or for a proposed investment. Previously, startups had to apply to an inter-ministerial board of certification for approval, and include a report from a merchant banker that confirmed the fair value of market shares.
This too is insane. A start up taking $20,000 to do proof of concept has to hire a merchant banker? Ludicrous.
There is a simple solution to this of course. The way that the rest of the world does this. Sure, start up shares and angel investments are made at above book value. But capital is capital, income is income, the two are different and should be taxed differently. The way the rest of the world does it is through a “share premium account” or some such name.
Here’s the nominal value of the shares. Say this is Rs 1 just to have a number. But people are buying them at Rs 1,000. OK. India’s current system says that the Rs 999 is income and is taxable at 30.9% unless everyone goes off and begs the government not to. The correct answer is that the Rs 1 goes into the share capital account, the Rs 999 into the share premium account and all of the Rs 1,000 is capital to the firm and is taxed at 0%. Very simple and very effective.
It’s even true that some people might possibly use this as a method of money laundering, the reason the tax was brought in in 2012 in the first place. But what’s the actual worry here? What loses more money in the medium to long term? Crippling the financing of start ups or allowing a bit of money laundering?
This argument actually being the one that has crippled India these past 80 years. The whole Nehru system of tight bureaucratic control, that Licence Raj, was to insist that everything must be right in detail by missing the larger picture. The entire point of the Manmohan Singh reforms, as carried on by Narendra Modi, is that forget the details, let’s get those big things right. Exactly what has raised the GDP increase from that Hindu growth rate of 3 and 4% up to the 8% which actually makes a difference, makes the country richer.
Taxing capital inputs to start ups is simply insane, India should stop doing it.