Misplaced enthusiasm

The taxman must stop harassing start-ups

The income-tax department has, for some time now, sought to crack down on unlisted companies that issue shares at a premium. This follows the amendment of the Income Tax Act in 2012 by the introduction of Section 56(2) viii(b), an “anti-abuse” clause that insists that investments at a premium that cannot be “explained” to the satisfaction of the taxman will be treated as income. This was introduced, incidentally, following the uproar surrounding the use of unlisted companies in the controversial distribution of 2G telecom licences. The income-tax department’s activism surrounding this clause had raised concerns in the start-up sector, where several rounds of funding are often offered at various different sorts of premiums or discounts to earlier valuations. And now it appears that the ministry of corporate affairs (MCA) has joined in the act, with reports that 2,000 start-ups have received notices from the ministry demanding that they explain why their valuation has fallen as compared to earlier rounds of funding. The tax department was concerned initially only with investments in start-ups by “angel” investors — the MCA has interested itself in all investments. Clearly the scope of intervention in the sector is being increased and not reduced.

The ministry’s intent is, no doubt, to seek to examine if the sector is being used to launder or conceal money. This is a laudable goal. But all such goals must be weighed against the costs of particular methods used to attain them. In this case, the harassment of start-ups has clear and stark costs. The sector is one of the few bright spots of the Indian economy, and has managed to attract an interest from foreign investors. Across the world, the nature of the start-up scene is such that it is far from easy to value a new firm. Not only do market conditions and expectations change between rounds of financing, different investors may be brought on board at different multiples. Demanding that the exact model behind the valuation of a start-up be made transparent reveals a worrying lack of understanding of the sector and of early-stage financing — which is less a science and more an art — in general. There is no clear, transparent and consistent way in which to derive a notional resale value of a company that has just a few tangible assets, less than half a dozen employees, and a minuscule market share. Investors bet on growth, and what they think the market and corporate dynamics will be. It is difficult to see how these will be able to provide a coherent rules-based model of their valuations that will satisfy bureaucrats.

The government, which has often boasted about its “Start Up India” initiative, must follow through on its promises to protect start-ups from the arbitrariness of officials. The first step should, of course, be to rein in the MCA. But the so-called “angel tax”, which takes away 33 per cent of angel investing in a premium, is also pernicious, and should be reviewed. The existing demands should be withdrawn, and cases in various tax tribunals against start-ups abandoned. The harassment of start-ups with little or no resources to fight ministries and the tax department must end.