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Is a quirk in the angel fund tax exemption blocking startups from acquiring and growing?

While this issue has been raised by startups before, the government’s response hasn’t exactly been reassuring even though it had previously signalled more flexibility for angel and investments.

In 2019, the Indian government said in Parliament that angel investments are exempted from taxation under the Income Tax Act, 1961. “Startups receiving investments from Ventures Capital Fund are exempt from taxation as per provision of Section 56, (2) (vii b) of Income Tax Act 1961. Angel Fund is sub category of Ventures Capital Fund under Category-I Alternative Investment Fund (AIF), hence, [it is] eligible for the same exemption,” Minister of Commerce and Industry Piyush Goyal said in a written reply. But as one angel investor recently found out, a quirk in the law means that if companies want to avail of this exemption, they must give up a lot of ways of deploying that capital.

Kushal Bhagia, a venture capitalist at First Cheque, pointed out on Twitter that “If your startup has raised Angel money, you can’t invest that money in Liquid funds – if you do – the Angel Tax exemption doesn’t apply to you.” Indeed, as a February 19, 2019 Gazette notification by the government states, “A Startup shall be eligible for [an exemption on taxation of angel tax investments] provided it has not invested in […] shares and securities.” (emphasis notification’s)

The notification may limit startups who want to use their funds to acquire equity in other companies in order to grow rapidly. “It is an issue,” Dhruva Rotti, a Partner at tax advisory Dhruva Advisors said on Twitter. He added that a provision in the angel tax exemption would make the revocation of the exemption apply retrospectively, potentially turning what may once have been an exemption into a back tax demand. That raises the spectre of harassment from tax officials, a recurrent concern among Indian businesses.

Government tries to reassure on harassment, but…

This concern is not exactly new; in Commerce Minister Goyal’s parliament response cited above, the government revealed that startups had already fretted about the issue in meetings. But the government’s somewhat impenetrable response to these concerns doesn’t exactly walk back on the potential for the angel investment tax exemption to be revoked if it turns out that this money was used to purchase securities. This is what Goyal’s response said, in part:

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Several round[s] of discussions have been held by Department for Promotion of Industry & Internal Trade (DPIIT) with the Startup ecosystem to address their concerns. Consequently, a notification […] was issued by DPIIT. Central Board of Direct Taxes (CBDT) vide their notification number S.O. 1131(E) dated 5th March 2019 has notified that provisions of Section 56 (2) vii(b) of Act shall not apply to consideration received by a company for issue of shares that exceeds the face value of such shares, if the said consideration has been received from a person, being a resident, by a company which fulfils the conditions specified in notification number G.S.R. 127(E), dated 19th February, 2019 of DPIIT.

Department of Revenue had earlier issued an advisory on 24th December, 2018 based on representations received from various startup companies that no coercive measures to recover the outstanding amount should be taken for startup companies, if additions have been made by Assessing Officer under Section 56(2) vii(b) of Income Tax Act, 1961 after modifying /rejecting evaluation so furnished under Rule 11 UA (2) of Income Tax Rule, 1962. (emphasis supplied)

All this goes to say: we’ll not bother startups on this exemption if they bought securities, as long as we had already figured out that they should not have been exempted to begin with and adjusted our tax assessment already. The corollary is this: if such an exemption was granted before, and scrutiny is later done, there may be a price to pay to the tax authorities.

Impacts creating subsidiaries: Rotti said that this “omnibus” restriction prevented even the creation of subsidiaries. “It isn’t technically an Income Tax matter. This needs to be addressed by DPIIT,” he argued. “In my view, DPIIT needs to provide certain exclusions for this.”

SEBI loosens regulations

SEBI in March signalled that it would ease up regulations surrounding venture capital and angel investment funds, and made the following changes:

  1. SEBI incorporated the definition of ‘startups’ as specified by the government into the regulations for angel and venture capital funds
  2. SEBI further allowed venture funds to invest in hitherto restricted sectors
  3. It prescribed a Code of Conduct for VCs and angel investors and the committees that carried out the functions in their organisations.
  4. It allowed such funds to invest in units of other alternative investment funds (AIFs) and directly in securities of investee companies.

Note that while investing in securities into angel funds is allowed, this doesn’t appear to mean that money invested by angel funds can be exempted from tax for investees.

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