Hundreds of Indian startups are still awaiting clarity on angel tax

Tax woes continue to haunt Indian entrepreneurs and investors despite efforts by the Narendra Modi government.

Earlier this month, India announced several steps to ease angel investment in the country, including giving startups a new definition and reducing their scrutiny. Yet, several entrepreneurs and industry bodies that spoke to Quartz felt that these new rules will only help upcoming ventures, and don’t do much for the existing ones, especially those who have already received tax notices.

“The current law presumes guilt and more often penalises the genuine investor and entrepreneur,” Paula Mariwala, founder and co-president of Stanford Angels & Entrepreneurs India (SAE India), told Quartz. “This has caused irreparable damage to the startup ecosystem in India as angels are putting their money elsewhere and entrepreneurs are having a hard time finding their first cheques resulting in unnecessary road kills of many a good idea.” Mariwala is also a member of the policy team at Indian software products industry’s think tank iSPIRT.

Angel tax is levied when a privately-held company raises funds at a rate higher than its “fair valuation.” Currently, India charges 30% in angel tax. Over the past several months, many Indian startups have received tax notices from the income tax department. Several of these tax demands include sky-high penalties.

On Feb. 19, the government relaxed norms for companies that qualify as “startups” and can avail angel-tax breaks. Now, an entity is considered a startup for up to 10 years after its incorporation as compared to seven years earlier. The upper limit for the turnover of tax-exempt startups has been increased from Rs25 crore earlier to Rs100 crore.

But all this has still not made it easy to be an entrepreneur in India.

Red-tape overload

Monika Jain, co-founder of mobile app commerce company Presto, which helps small and medium enterprises (SMEs) go online to sell products or services, received a scrutiny notice back in July 2017.

“The implications would be 30% tax and a penalty that could run to almost 300% of the tax amount,” Jain said. “For a domestic fundraise of Rs60 lakh, the total tax exposure comes to almost 100%. That was a sword hanging by our neck.”

Despite the limited financial and manpower resources at her disposal, Jain has been going through the entire rigmarole of angel-tax red tape. It began with Jain and her chartered accountant addressing queries from the central board of direct taxation (CBDT) and went on to Presto having to spend on legal representation and due diligence.

“We did pay out of our bounds for that but the downside of not using them was too huge to be ignored,” Jain said, adding that for a company with an monthly cash-burn of around Rs15 lakh, spending Rs3 lakh on legal fees was a sizable pain point.

After over a year of back and forth, Jain’s case was resolved without a hefty payout. However, the process is subjective and not every startup has escaped the plight.

As of Feb. 25, iSPIRT and online community network LocalCircles had already submitted with CBDT appeals for nearly 170 startups that have been served unfair scrutiny notices and are struggling with angel tax red tape, LocalCircles chairman and managing director Sachin Taparia told Quartz. CBDT will look at each case individually and Taparia is hopeful of a resolution in the next two weeks.

Day-to-day dilemma

Meanwhile, businesses are suffering as startups struggle to retain their headcount, pay salaries, and incur other business expenses, Jain and other entrepreneurs said. As for investors, they would rather steer clear of startups dealing with angel-tax issues, adversely affecting a firm’s ability to raise further funding and hurting their valuations.

“…show cause notices under 179 (as a result of the company not paying their liabilities) and or prosecution of directors under the Income Tax Act also endangers their personal wealth and is extremely demotivating and distracting for genuine founders that have pledged their personal wealth to run bootstrap businesses,” Rashmi Guptey, chief financial officer at venture capital (VC) fund Lighbox India, said.

Aside from monetary strain, founders also see their peace of mind disturbed, altering their attitude.

“Startups who have got the notice once are obviously a bit cautious about raising funds from angels again,” Manish Singhal, founding partner of pi Ventures, an artificial intelligence (AI), machine learning and Internet-of-Things (IoT) focused early-stage fund. Moreover, it also sets a poor precedent for upcoming entrepreneurs.