Angel and tax combine as naturally as do gold and rust, or, say, deer and hyena. That, of course, is in the real world. In the world of Indian taxation, things are a bit different. The so-called Angel Tax, introduced in 2012, has undergone various bits of cosmetic surgery, in order to make this grotesque mutant look less threatening, but it remains a menace to Indian startups. The latest attempt to soothe frayed nerves in the startup universe has been a clarification that bars the tax from haunting the premises of startups recognised by the department for promotion of industry and internal trade. Instead of pulling a fang or blunting a claw of this tax monster, what needs to be done is to slay it once and for all.
The Angel Tax was introduced to foil money laundering by way of setting up a company, a presumed startup, investing in it at an inflated valuation, and then taking funds out from the company in assorted ways ranging from bogus expenses to loans that are eventually written off. The Income Tax Act was amended to tax as income the excess of the capital invested in a closely held company above its fair market valuation. The applicable tax rate is 30.6 percent. If it were tax-evaded income that has been invested in the company, even if it escaped taxation at the source, it would get taxed at the stage where it is being dressed up as capital investment — this is the taxman’s logic.
There are a number of things wrong with this approach. One is the philosophy. Across the world, we have stories of evil kings ordering the mass murder of all children born in a particular period, because it had been prophesied that one of those infants would grow up to end their rule. Krishna and Jesus both escaped such slaughter. Instead of targeting the wayward, this approach presumes everyone guilty, and it is up to the accused to prove their innocence, instead of the prosecution proving the guilt of the accused. The preferable approach is to presume innocence till guilt is established. That is, trust but verify.
Establishing Fair Market Value
Another problem is the difficulty of establishing the fair market value of something that does not have a market as yet. After bringing non-resident investors within the ambit of the Angel Tax in the Budget for 2023-24, the tax department has prescribed five valuation methods to vet such investments: comparable company multiple method, probability-weighted expected return method, option-pricing method, milestone analysis method, and replacement cost method.
These valuation methods are not so much sophisticated as sophistry. These are meant to give the sceptical public the impression that the government actually has scientific methods of assessing fair value, and that there is nothing arbitrary about a tax demand on a startup. Consider a magician, whose act is to put a pretty girl into a wooden box on a table, close the lid and saw it into two, to the horror and amazement of the audience, only to later resurrect the young lady fully intact and twirling for the audience. He would have a number of props at hand to distract the audience from his actual actions that create the illusion of vivisection. The tax department’s methods of valuation are props of distraction from real, rather than illusory, use of a cleaver on a young company.
Consider the replacement cost method. Consider Microsoft or Apple when they started up in garages, with some low-value equipment and high-voltage entrepreneurial imagination and energy. Would the fair value of the startup have been the cost of replacing the little bits of electronics and late-night pizzas they ran on?
What is a milestone for a startup depends on the nature of the startup. The milestones for a company developing an mRNA vaccine would be very different from those of a startup developing games. Do taxmen have the competence to assess the value of diverse startups at hard-to-determine milestones for different startups in widely different sectors? To talk of option pricing in the context of startup valuation is to give the game away completely. An options market exists because different agents see different probabilities of the underlying asset achieving different price points in the future. If these estimates did not diverge, there would be no market. These estimates would need to converge, for them to yield an estimate of fair value. Venture funds or angel investors value startups with very wide variation. Some venture capitalists invest in a particular startup because they see it creating significant value in the future, others shun them because they do not. Whose estimate is right, Mr Taxman?
What sense does a comparable company-multiple method make when startups are inherently not comparable? The time of Me-Too startups is over. Just by operating in the same area, two companies do not become comparable. The energy, dedication, capability, and excellence of the team could be a crucial differentiator, for example. The probability-weighted expected return method is used for a mature private company, not a startup. In fact, all the valuation methods are appropriate for mature companies, rather than for startups. Then again, some startups have far more value for particular investors than for others, for strategic reasons. The kind of money Facebook laid out to acquire Instagram and WhatsApp would not have made sense for Samsung or Apple, for example.
Curbing Money Laundering
There is nothing wrong, of course, with the goal of stopping money laundering. If attempts to establish the fair value of a startup is too complex, how does one go around checking money laundering? Essentially, there are two prongs to a viable strategy. Institute a unique legal identifier for all companies and investors, so as to trace the beneficial ownership of any company anywhere in the world. This is a global challenge, and not a local one. However, the project is gaining regulatory support in country after country, Britain having mandated clarity on beneficial ownership some time ago.
The other is deploying advanced analytics to track fund flows into and from companies. In India, the Account Aggregator framework allows a company to compile all its financial flows in a single place, voluntarily. Make it mandatory for startups and financial companies to give access to tax and other regulators to access such data. It would help startups develop financial discipline, as well.
The biggest challenge in cleaning up finance, is, of course, cleaning up political funding, in general. Corrupt and opaque funding of politics calls for suborning the formal system of corporate governance, audit, and transparency, and, thus, enables all kinds of sharp practices.
Well, the government has excluded companies registered with the department for promotion of industry and internal trade from the ambit of Angel Tax, hasn’t it? Why should anyone complain? Which bunch of youngsters teaming up to form a new company would know how to get registered with the said department? If the process of registration is as simple as filling a web form on their site, what check would that provide? So, there would have to be a vetting process. That registration process would become another Licence Raj. Is that what India needs now?
Regulatory deficiency in deploying the latest available tools for tracking and analysing fund flows should impose its cost on the regulators, not on India’s startups. They deserve better. The Angel Tax should just go.
Disclaimer: All views expressed in the article belong solely to the author and not necessarily to the organisation.
The article was first published in Money Control as The Angel Tax should be scrapped, not modified on October 19, 2023.
Posted by Rehmat Arora, Research Intern at IMPRI.