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Angel Investors Beware: Funding Startups Could be Classified as Income


Startups, founders and Angel investors, please note the change in Budget 2012 that has been slipped in, innocuously. An investment in any private company could be classified as “income” unless you can justify the investment and valuation to a tax officer. Such income is taxable.

Look at the “Memorandum” under section “Share premium in excess of the fair market value to be treated as income” (Page 8).

It is proposed to insert a new clause in section 56(2). The new clause will apply where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration
for issue of shares. In such a case if the consideration received for issue of shares exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares shall be chargeable to income tax under the head “Income from other sources. However, this provision shall not apply where the consideration for issue of shares is received by a venture capital undertaking from a venture capital company or a venture capital fund.

Usually a startup gets funding from an angel investor in exchange for equity. The valuation of the startup is usually based on an idea, with very little else to support it. (Hardly any computers or machinery or even hard investments by the founders). A new startup with an idea and perhaps a prototype built at home may get a Rs. 10 lakh funding from an angel investor for 10% of the company.

Typically, such startups have very little invested capital. So let’s assume the above startup had Rs. 90,000 as paid up capital by the founders, or 9,000 shares of face value of Rs. 10. To give the new investor 10% of the company, the startup will issue 1,000 shares (1,000 out of a total of 10,000 shares – the old 9,000 plus the new 1,000 – is around 10%).

Since the investor pays Rs. 10 lakhs for 1000 shares, he gets the shares at a value of Rs. 1000 per share. The “face value”, though is Rs. 10, so the investor has paid more than the face value. Startups are generally private. Finally, the investor is an Indian resident.

With those three conditions met – and they will be met for most angel level investments in India – the income tax department may not classify the money received as an investment, from April 1, 2012. They can say, listen, this is “income” to the company on which the company must pay tax.

(Paying tax is not a good option. The angel invests X, the startup pays 30% of X to the government; a 30% waste of good money, if you ask me.)

And if you’d like to argue otherwise:

Further, it is also proposed to provide the company an opportunity to substantiate its claim regarding the fair market value. Accordingly, it is proposed that the fair market value of the shares shall be the higher of the value—
(i) as may be determined in accordance with the method as may be prescribed; or

(ii) as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value of its assets, including intangible assets, being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature.

You’ve spent all that time convincing an angel investor, now you can spend some more time convincing an Assessing Officer that your idea is an “asset” that is valuable enough.

Supposedly this rule was to avoid weird investments that would route shady money into equity of private limited companies. But like @tejus_sawjiani said: It’s like gassing a room to kill a mosquito.

What should you do?

If you’re a founder, either raise your capital from angel investors fast (before April 1, 2012), or try a workaround.

You can try a milestone based approach where each milestone will involve a valuation that can be justified (although I have little faith in a tax assessing officer’s ability to understand startup valuation based on implementation).

The other method is to use convertible debentures, where you take on the investment as debt, and as time goes by it converts into equity. This has the hurdle that the investment may be classified as equity on the whims of the tax officers, and at each conversion point to equity, the assessing officer needs to be satisfied about the valuation.

Another is to use a sweat equity approach. Say you give the investor shares at “face value”, and allocate yourself “stock options” that vest over the next two years, and give you additional shares equivalent to 90% of the company. This removes the problem of this clause, but introduces the problem that you have been given stock worth a large sum, for no consideration – is this taxable as income? Can you do this easily? I don’t have answers offhand.

New thought: Since the law applies only to companies, you might be able to start a Limited Liability Partnership where there is no concept of “shares”. Later when you are ready for a VC fund you can create a company and transition assets. (Note: transferring assets like knowledge or money which can be removed and reinvested, is easy. Transferring real assets like property and even tables and chairs will involve stamp duty and/or capital gains taxes which can be expensive. But for service oriented startups which don’t have too many assets, this may be an avenue to consider. However, note that a single tiny amendment will easily include LLPs into the ambit of this rule.

Finally, just find a non-resident angel investor, or pitch to a Venture Capital fund. This sucks, but it’s a problem our budget has given us.

If you’re an angel investor, consider creating an off-shore entity that can invest in startups. There are other issues with owning offshore entities as a resident; the Budget requires mandatory filing and then, can reopen your books for 16 years for scrutiny (versus six for a resident). Plus, the investment will be subject to wealth tax and if you get a great exit, you will be charged capital gains tax at 30%, and so on. It’s messy, but if you can, get a good accountant to validate the offshore approach.

(And please let me know! I can put it up here to help other angel investors).

Secondly, you can register as a VC fund. It’s painful but it absolves your investee companies from explaining things to a tax officer and so on.

Lastly, you can consider the alternate approach of using convertible debt. Just don’t call them “preference shares”. Or the sweat equity approach mentioned above. Also, a real accountant will have a usable opinion (I’m not an accountant).

This is a way to kill startups, cutting off what is a valuable source of funding. You might consider this is bad only for tech startups, but way too many startups, in all fields, start with money from friends, family and others, at a “higher than face” value. This is to account for the fact that the guy or girl on the ground is going to do all the work. Today, it doesn’t take too many physical assets to build a business, so capital comes in to hire people, rent an office, travel or advertise, but apparently the government would prefer you take a bank loan for this purpose than have your friends or colleagues pitch in for a potential equity state.

If either of you ever join politics and become a finance minister, please consider removing this clause.

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