The UPA government has suggested a measure in the Union Budget 2012 which will kill angel investing and give birth to still-born startups in India. The Budget has introduced a new clause which will treat all individual investments (which will include genuine angel money also) in a company as "income from other sources", and they will be subject to a tax of 30% at the hands of the companies (including all genuine startups).

The government also brings in a concept of fair market value to calculate this taxable income. So the consideration received in excess of face value and also the fair market value will be considered for taxation. The problem is fair market value has to be "substantiated" to the satisfaction of assessing officer who is not an expert on valuation of especially emerging businesses (how will they value a Facebook or Twitter or an InMobi?).

The clause is reproduced from the Budget documents here:

Section 56(2) provides for the specific category of incomes that shall be chargeable to income-tax under the head "Income from other sources".

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 incometax 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.

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.

This amendment will take effect from 1st April, 2013 and will, accordingly, apply in relation to the assessment year 2013-14 and subsequent assessment years.

[Page 8-9 of memorandum (PDF doc)]

The government takes pride in the fact that it has exempted venture capital investments from this ambit, and has only brought individual investments in the tax net. This shows government's clear lack of knowledge of investment value chain in startups.

Angel investment or investments from individuals such as friends and families are at a very early stage of the company where VC funds usually do not come in. Only after the company sees a significant traction or the proof of concept is established, an early stage VC fund will invest in a startup. So the investment from "persons" comes in at the earliest stage.

A startup will not get institutional money at a very early stage, so that gap is filled by high net worth individuals and successfull entrepreneurs who will provide the capital to startups as their personal investments. From a startup's point of view, there is no difference between individual capital  or institutional capital, it's just the startup capital for them. They need that to establish the business and grow to a stage where it can absorb insititutional capital. And when the institutional capital come in, the individual investors usually exit. This is the way investment value chain works, to which the government seems to be closing their eyes.

So there is a fundamental divergence of views between the government and the investment industry in treating the early stage investment. The government sees only VC funds as genuine investors in startups while it sees individual investors suspiciously as if they are not genuine partners in building a startup. The point is why should any form of investment be distinguished from the other? An investment is an investment whether it's from an individual or a company or a venture capital fund.

There can't be a more regressive step than this, and it clearly shows how backward is our establishment in understanding new investment models.

As a first step, all industry bodies and angel networks need to convince the establishment that angel or an individual investment in a startup is an asset class just like venture capital. If the government listens and appreciates this, the startup industry can be saved and lakhs of jobs generated by these startups can be protected. Finally, one last point. Privately held companies generate many more jobs than listed enterprises and contribute to India's GDP growth, so why would they be penalised? They should be encouraged instead.

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