Pranab rolls a grenade at funding angels

Ever so silently, finance minister Pranab Mukherjee has rolled a grenade on Angel Investor Avenue, where cash-strapped first-generation entrepreneurs try to come into being.

Among the minutiae of direct tax proposals is the one (Clause 21 of Section 56) on start-ups that receive funding from angel investors and non-registered venture capital funds.

And what does it say? They will have to pay 30% tax, too.

Although registered venture capital firms are exempt, the new tax on unregistered start-up backers is ill-conceived and is probably a kneejerk response to the 2G scam, said Saurabh Srivastava, co-founder, Indian Angel Network (IAN), which has funded over 30 start-ups in the last six years.

“It is like dropping an atom bomb on a city because one criminal needs to be killed,” he said.

Ravi Mahajan, partner, tax and regulatory services, Ernst & Young India, feels the tax may be aimed at tracking and weeding out black money.

Typically, ‘angel investors’ are not a recognised category, hence not registered. So, all start-ups that rely on angels are now liable to pay 30% tax on investments received.

For instance, IAN member Raman Roy has angel-invested in over a dozen start-ups. “If this clause were existent earlier, many brilliant entrepreneurial initiatives such as Spectramind wouldn’t have happened,” said Roy.

The ‘father of India’s BPO revolution’ founded Spectramind in 2000.
Mahajan said the new tax would hurt genuine angel investors.

“Any valuation more than the fair value will be taxed which will adversely impact the money raised from angel investors. If funding is based on valuation that tax authorities don’t agree with, then the companies will have to pay the difference between the forward-looking investment by the angel investor and the valuation as assessed by the IT department, as tax — even if they do not make profits on the same. This will impact profitability of smaller companies and lead to longer break-even,” Mahajan said.

Angel investors make available the initial capital, starting from Rs10 lakh to Rs1 crore or more, to new start-ups. These set of investors work towards promoting entrepreneurial initiatives and ensure such activities continuously flourish. Various measures enunciated for small and medium enterprises (SMEs), however, will now come to naught, feels the angel investor community.

 “Angel investors pay for the idea which is yet to take the form of a commercially viable business model. Google was created as an idea with just $10,000 and the company is worth hundreds of billions of dollars now. If the same $10,000 were to be given to an entrepreneur in India now, the tax department will impose a 30% tax on the money raised,” said Roy.

The definition of fair market value cannot possibly be determined by any valuer and certainly not by a tax authority but only resides in the minds of the entrepreneur and the investor, said Srivastava.

“A tax officer could legitimately see the value as close to zero, whereas any angel investor who chooses to invest will do so because he / she sees great value and would buy shares at a huge premium because they would want the entrepreneur to hold a majority of the company,” he said.