Investment above Fair Market Value – no more Angel tax for Startups

In this session we take up a long pending issue of “Angel Tax”. It has been given partial reprieve recently, under StartupIndia plan. We also discuss how startups can raise money from Angels, without getting trapped in fair market value rule of finance act 2012.

Sanjay Khan speaks on the problem, the latest announcement and the way out for startups to raise equity without DIPP route, in the below given google hangout video.

What is this issue of Angel Tax? And what changes after new announcement?

Startups receive equity infusions from various sources. One of the most lucrative and internationally prevalent source is the Individual investor (Angels).

In India income tax department is skeptical about angel investment. This is because, at times angel investment was misused to channelize black money. Artificial valuations is mostly the doubt in mind of income tax authorities.

As per, Finance Act 2012, capital raised by an unlisted company from any individual against an issue of shares in excess of fair market value would be taxable as ‘income from other sources’ under Sec 56 (2) of the I-T Act. This came to be popularly called as angel tax.

So, if fair market value is say e.g. Rs. 10 per share and a startup receives Rs. 15 investment from an Angel investor. Income tax treats this difference i.e. Rs. 5 per share, as income.

As per the above provisions, the angel investments are subject to assessing officer’s approval. The jurisdictional assessing officers of income tax enjoy the discretionary powers. Instances of misuse of these discretionary powers by assessing officers created problems for startups.

Many startups are not serious about the documentation. Mostly, such startups get into problems due to lack of documentary evidence about their valuations.

Govt. of India recently announced a change under StartupIndia policy of DIPP. A Central Board of Direct Taxes notification, dated June 14, made the required changes to Section 56(2)(viib) of the Income-Tax Act, exempting startups raising funds from angel investors. This is limited to the startups approved by DIPP.

Is it available to all DIPP registered startups?

No, not to all startups approved or recognised by DIPP.

There are three kinds of startups now.

(a) General Startups, that have not applied to DIPP or are not even eligible to apply to DIPP.

(b) those who applied and got recognised by DIPP but did not apply for Income tax exemption.

(c) those who fall under (b) and also got the income tax exemption approval of the inter ministerial board of DIPP.

Only the third (c) category of startups are eligible. These startups need not worry about the assessing officer discretion now. The benefit is available so long as they enjoy the income tax exemption under startup policy.

So, if this is not applicable to all startups, does it mean other startups cannot raise equity from Angel investors at all?

The Finance act 2012 provision does not bar angel investments. Startups not under (c) above can raise the investment from Angels (individual investors). The limitation is that the valuations in such cases will  be subject to examination by assessing officer approval.  They have to extra careful about the valuation at each round of funding.

Such startups should get a professional third party valuation reports. Get a valuation reports for all rounds of valuations with proper documentary proofs. You can face the assessing officers with proper documents without any fear.

The recent hype created in media was mainly arising from down rounds. That is when the new round of investment was done at a lower rate than the previous round. This led to income tax doubting the misuse.

In such challenging valuation situations like down round valuations, the startup can get a professional third party valuation from 2 or 3 sources. This way they can deter the assessing officer’s misuse of discretionary power as well as stand any litigation test, if put through.

In essence, a startup can raise honest angel investment at right fair market value. A professional valuation exercise with all objectivity can help you cover the risk.

iSPIRT’ stand

Startups ecosystems in developed countries enjoy a favourable investment climate that proactively promote and protect the angel’s investments.

Government of India should show give clear signal of favourable investment climate in the country.

Government of India should think of measures that can deter black money getting invested in the Startups, instead of doubting each and every investment. For this Govt. should repeal the the provision introduced by finance bill 2012 should. Discretion to assessing officer is not serving the cause of building investment climate.

India seriously needs a policy that promotes angel investments in general, with responsibility of money invested taken by investors rather than Startups.

Announcing the angel investor office hours in Bangalore (soon in Mumbai and Delhi as well)

How to hack your seed round in India, got 63 emails, comments and twitter messages asking me to take the post to its next logical step.

The 3 biggest issues entrepreneurs raised were:

1. They dont have the email addresses of these angel investors. Even if they did send them an email, responses were slow or went into a “black hole”.

2. The angel networks in particular have a fairly arduous process to filter, select and decide on new companies.

3. Many angel investors were not proactive in telling them what areas (sectors) they were interested in funding, so entrepreneurs could tailor their pitch to be more specific and target the right person.

I am extremely pleased to announce that in Bangalore (soon in Mumbai and Delhi as well), we will have a few of the top angel investors from IAN (working on Mumbai Angels and others as well, stay tuned) who are committing to office hours each week to meet entrepreneurs and provide them quick feedback on their funding options.

From January 2013, five of the most prolific IAN investors, Venkat RajuManav GargNagaraj PrakasamSharad Sharma and Sundi Natrajan will hold monthly office hours in 2 locations – the Microsoft office at Lavelle Road and Eka Software offices in Outer Ring Road.

Update: Anil Joshi of Mumbai Angels has also agreed to host office hours in both Bangalore and Mumbai once a month.

Each session will be for 30 minutes per entrepreneur and a max of 4 entrepreneurs will be given time on a first-come-first-serve basis every month. Only one session per entrepreneur per year will be allowed.

Second, after each investment led by these investors they will write a quick note to tell us more about why they decided to invest. This will tell us more about what their thesis was, the trends they were betting on and other relevant details.

Finally each of these investors will share their investment thesis for 2013 and the sectors or areas they have expertise in or are passionate about. For example, Sharad’s an expert in Internet and advertising, whereas Sundi is passionate about education.

I am very excited that they are committing to these office hours. As entrepreneurs we will get a chance to interact with them and get their initial feedback so we can fine tune our plans and strategies to maximize our funding chances.

I do have one request: We’d like a volunteer to help program manage this effort. You should be willing to commit about 1-2 hours per week. If you are interested, please send an email to: mukund at thrisha dot com.

If you are a seed investor and you’d love to join this program, do send me an email as well.

P.S. A few folks have been asking me about other cities, such as Chennai, Hyderabad, Pune, etc. I wont be able to commit to these investors coming to those cities, but will try and get a few more local investors from those cities to hold office hours.