Last week, the income tax department sent notices to startups asking why shares sold by them at a premium should be exempt from tax. The notices have been sent only to startups not registered with the government. The claim is that shares sold at a rate different from a “fair market valuation” must involve the generation and use of unaccounted money. The difference, or the premium, should therefore be treated as income and taxed. This issue, also known as the angel tax, has been in the news since 2018. At that time, the tax and late payment fees demands were sometimes more than the original funding amount. Earlier, the tax was levied only on investments by Indian residents, but the Finance Bill 2023 has extended its applicability to non-resident investors as well. This tax places unreasonable discretion in the hands of officials and is counter-productive to the goal of fostering a startup ecosystem.
What is fair market valuation?
The most obvious issue is arriving at a fair market valuation. Does every organisation have to be valued by everyone else in the same way?
Consider a founder who runs a tech startup that is asset-light. Her view is that the valuation of her company is Rs 100 crore. Most people may find this overvalued and choose not to invest. But she manages to find an investor who believes in her vision, is convinced about the valuation, and is willing to put up money for a piece of equity in the company. This seems like a transaction between two consenting adults.
The tax department, however, believes that there are only two ways to value a company: book value or the discounted cash flow method. If the valuation exceeds the one arrived at by a tax officer, who generally is not involved in the business, then foul play must be involved. From the administration’s perspective, differential viewpoints on valuations cannot exist. If, in subsequent years, the firm’s revenues do not bear out the projections made at the time of valuation, then there is even greater suspicion of the business.
It is possible that some startups or investors have been deliberately evading taxes. Others, however, could have made genuine mistakes in their valuations. It is also useful to remember that valuations are subjective. There is no one correct way. Some of the world’s biggest success stories have been made on the back of venture capitalists taking a bet on valuations of startups that may not conform to either of the methods. Many startups fail, but those that succeed often disrupt the status quo for the better. These organisations are treated with suspicion in India. The cost of capital for startups goes up, and they are effectively blocked from receiving funding even if both the donor and receiver are convinced of the soundness of the investment and are willing to take risks.
If a firm wants to get an exemption, it has to register with another government portal and undergo scrutiny by tax authorities. Considerable time and bandwidth are spent in obtaining this, or answering tax notices, or litigating with the government to justify the method of valuation; time and bandwidth that could have been more productively spent in running the business. The government’s own time and bandwidth will be better spent focusing on core public goods. It is not surprising that many startups prefer to register in jurisdictions such as Singapore, which has a less cumbersome tax regime.
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Rule of law in tax administration
The angel tax issue is the most recent example of excessive discretion in the hands of officials. There is no reasonable way for a tax officer to know the fair price of a share. Firms already register with the Registrar of Companies (ROC). The case for additional registration on another portal and applying differential exemptions to those who don’t is weak. This is especially the case as the rules for obtaining exemption are so constricted in how they define “innovation”, that less than 2 per cent of startups have been granted the IT exemption. The discretionary power of officials discourages entrepreneurship and diminishes the foundations of a market economy.
There are two levers for taxation – income tax on individuals and corporate tax on the firm’s net revenue. There are live policy questions around the world on how to avoid double taxation with corporations, the tax income of multinational corporations, and how to treat the carried interest of PE/VC funds. The decision that tax policy in India takes on these questions has to ensure that taxes have as little a distortionary impact as possible. Both instruments of income tax and corporate tax are available for startups and their investors. With a rationalised income tax and corporate tax regime, there is no case for subjecting capital raised by startups to the vagaries of valuation methods decided by officials. High taxes and cumbersome administrative processes disincentivise investments, which is detrimental to economic growth.
Renuka Sane is research director at Trustbridge, which works on improving the rule of law for better economic outcomes for India. Views are personal.
(Edited by Zoya Bhatti)