New angel tax notices spook investors, start-ups; trip fund-raising efforts

Differences over 'fair value' of fledgling firms makes assessment difficult

Last week, angel investor Vikram Chachra got a text asking: “Is this legit?” The message, from a founder of a start-up that Chachra and others have invested in, was accompanied by a snapshot of an income tax (I-T) notice asking for copies of tax returns, bank statements, correspondence, ledger details, and more. 

In the past month, Chachra, an active angel investor and partner at early-stage fund 8i Ventures, said five of the dozen companies he had funded had received such notices.

This second wave of I-T notices going out to start-ups on the back of an “angel tax” that came into effect in Union Budget 2018-19 is giving investors and entrepreneurs the jitters. 

The angel tax is a 30.9 per cent tax levied on investments made by external investors in start-ups or companies. However, the entire investment is not taxed, just the amount considered above “fair value” valuations of the start-up which, classified as “income from other sources” in the Income Tax Act, is liable to the angel tax. 

The problem is that start-ups are valued subjectively on the discounted cash flow model, which does not take into account factors such as goodwill and can result in differences of opinion on what constitutes “fair value”.

This means that start-ups still trying to find their feet suddenly have to pay higher taxes than needed. Given that start-ups are already a high-risk game, undue attention from the tax authorities can jeopardise the potential of a growing venture that might be trying to raise a Series-A round of funding where foreign investors may be showing some interest. 

One investor who declined to be identified said that she had met with tax officials and believed that scrutiny in the last two months has become widespread. 

“I met with an I-T commissioner to understand what’s going on and the thing is, it’s all algorithmically driven, so the software selects the companies for scrutiny.” 

What happens next is that IT commissioners have to investigate the allocations they receive to verify that the transaction is in order. If they are not satisfied with the paperwork, they go ahead and pass an order for tax collection on the funds raised. The company in question then has to go in for appeal.

Siddarth Pai, founding partner of venture capital firm 3one4 Capital, said the entire section was inserted to plug the laundering of money through start-ups. “Unfortunately, now this law is being used against bona fide start-ups and effectively a company is being penalized because of a valuation method,” he said. 

According to Pai, at least 15 start-ups who have recently been served the notice have contacted him for guidance. Start-ups which are raising money through legitimate channels are now being asked to provide the financials of their investors, which is not reasonable in the case of a start-up when it might be funded by, say, 10 different venture capitalists or angels.

This is exactly the problem facing entrepreneur Able Joseph who runs a match-making start-up called Aisle. He has been served the notice earlier and his big challenge is getting the I-T returns of multiple funding partners who are all across India. 

To complicate matters even further, Pai said the damper is that companies have to cough up at least 20 per cent of the taxable amount demanded in order to go in for an appeal which, of course, makes the start-up journey all the more difficult. 

Vipul Singh, co-founder of Aarav Unmanned Systems, received a notice from the tax office a month ago and, on the advice of his accountant, asked a local chartered accountant to represent the company at the I-T department in Varanasi where the case was being looked at. 

Singh said what took weeks to explain to the assessment officer was sorted out by the local chartered accountant in five days. “There’s no structure to their assessment and it’s more on the discretion of the officer who has called for it,” said Singh. 

Manik Mehta, an entrepreneur who runs Leaf Wearables which makes safety devices and who has just cleared his notice, said the tax authorities questioned why his company’s financial milestones were reached “earlier” and how a certain valuation had been arrived at.

“When you’re forming a company without a single product, then your valuation can vary widely when you are raising money pre-revenue,” said Mehta. “There is a computational loophole and that needs to be fixed which is what everyone is struggling with.”

Angel investors agree. “Young companies who have a long way to go in building competence and capabilities which result in job creation should not be treated like shell companies that launder money, especially when fund-raising is being done to capitalize a venture,” said Chachra.

CAUSE FOR WORRY

By the law 

• Angel tax is 30.9 per cent on amount that exceeds the fair market value of unlisted companies
• Stipulations under KYC call for financial details of all investors who fund firms 
• Model of discounted cash flow doesn't account for goodwill in start-ups

Start-up woes

• Angel tax notices trip fund-raising efforts
• New ventures struggling to run businesses get hit by the taxman
• Contesting I-T notices is legally unviable for most start-ups trying to get off the ground

 

With inputs from Alnoor Peermohamed