1. Angel Tax is a Tax on Angels (or investors)
MYTH
Angel Tax is an invented term. There is no legal definition for it. It has come to mean a tax on the Startup for raising funds at a valuation greater than the Fair Market Value thereby counting it as income(rather than investment). This is covered under section 56 of the Income Tax Act, 1961.
2. Angel Tax is a tax on profits
MYTH
Angel Tax is levied on the investment received from Angel Investors. The profitability of the startup is not related to this. In case the startup is making losses, or if the entire amount would be towards cash burn, then this amount can anyway be set-off and no tax is payable in those cases.
3. Angel Tax involves questioning of the investors
Partly MYTH
The Income Tax Department questions the source of funds to ensure there is no money laundering. This is under section 68 of the Income Tax Act. This has little relation to the Fair Market Value or the startup or the valuation or the amount. This is a power of the Income Tax Department to determine the source of funds. Angel investors file ITR returns religiously. Proving the source of funds can sometimes be as simple as furnishing the IT Return.
4. Startups are getting notices
Partly MYTH
The current set of notices being sent by Income Tax Department pertain to transactions conducted in 2013-15. The Startup India Programme was launched in 2016. Till date, no notice has been sent to any entity that had obtained exemption from Department of Industrial Policy and Promotion. No entity that was a Startup at the time of transaction has received a Notice. Any notice that is being received by startups is if they became DIPP certified AFTER the transaction. They were not Startups at the time of the transaction. Also, the Income Tax Department does not identify a Startup at the time of sending a notice of scrutinising a case.
5. Section 56 applications are not being processed
MYTH
The grand total number of applications received by DIPP by 1हों October 2018 was ONE. Yes! Only one person had actually applied for the exemption from angel tax. The form is available online and is Free of Cost. There is no extra cost and despite that only one startup filled the form. The furore in the media is hilarious. There are petitions on change.org and other places regarding exemption but no one has applied.
6. Startups are exempt from tax for the first three years
MYTH
The tax exemption is available for startups for a period of three years in a period of Seven Years. Out of Seven, the Startup can choose which set of Three years should be exempt from tax. The three years have to be in a set but it is at the discretion of the Startup.[1]
(My favourite) Example to understand the issue.
Bonafide Startup
"True dot AI" raises INR 100m at a valuation of INR 500m (20% stake)
कम्पनी जूं खसिसतयूं
o Declared domain: Artificial Intelligence
o Assets as per balance sheet: Nil
o 3 employees other than founders
o No revenue projected for next 18 months
o Company Age: 8 months since incorporation
o Merchant banker certificate: Approves based on assumptions
Malafide Startup
Pratham owes Aditya INR 100m for an illegal property transaction. If Pratham pays Aditya, Aditya will have to pay 30% tax on it.
आदिस्य हिक कम्पनी ठाती: "फेल्स डाट ऐ आई" ऐं विकरे थो 20% पती प्रधम खे रुपया 100 ऐम.
कम्पनी जूं खसिसतयूं
o Declared domain: Artificial Intelligence
o 3 employees other than founders
o Assets as per balance sheet: Nil
o No revenue projected for next 18 months
o Company Age: 8 months since incorporation
o Merchant banker certificate: Approves based on assumptions
The two transactions look very similar from the outside. Tax is evaded in the second case by disguising the payment as an investment. The tax department[2] would like to tax all cases like the second one. The startup community would not want the first case to have any regulatory run-ins.
[1] While this was not related, some news articles mention this as a policy failure. I couldn’t resist.
[2] हिउ कयोवेंदो आहे हिक कम्पयूटर ऐसिसटेड स्क्रुटनी सिलेक्शन (सी ऐ ऐस ऐस) मार्फत जो घटाईंदो आहे दस्ती दखल-अंदाजी.