Direct Tax Code – Will it Derail the “Domestic” Angel Investing Movement

13 April, 2012

India’s growth in the last couple of decades has been nothing short of breathtaking. That comes from sonme unique advantages of outsourcing tasks and skills from expensive labor markets, mobile device-linked productivity, investment in large scale infrastructure development and expansion of consumption to the ever-increasing classes of Indians with disposable income.

We are also uniquely poised to take advantage of what’s often called our ‘demographic dividend’. The Economist, in it’s Oct 7th edition, added an interesting dimension, suggesting that the demographic dividend is likely to yield even more benefits by creating a new wave of entrepreneurship, unlike anything we’ve seen before in India and I dare say, perhaps never seen in the history of the planet. That we are a land of entrepreneurs and jugaad has become a recurring theme to explain the surge of capital that’s come into the country to back established entrepreneurs.

Unfortunately, short-sighted policy-making keeps giving undue relative advantages to the “stock market” syndrome in India, which is the pinnacle of wealth creation, but hardly the foundation. The brazen differences in treatment of long-term capital gains, between unlisted and listed equity securities (i.e. those traded on an exchange), in the recently unveiled Direct Tax Code is a stark example of this defective policy.

How can one quality of long-term value creation warrant Zero Capital Gains tax to the entrepreneur and it’s investors whereas another equally, if not more, important form of wealth creation – a potential sale of a high-quality emerging business in the private domain – attract a 30% Capital Gains Tax to it’s entrepreneurs and investors? Are we suggesting that an acquisition of a business before it can go public is a weaker economic good than a stock market gain? On the contrary, the strength and depth of robust capital markets in country has a strong correlation with the activity in the small and medium business M&A market.

This skewed treatment, which will reward private company shareholders to take a company public (IPO) just so that they can miraculously end up making 30% more money due to a tax regime, is beginning to create negative ripples in the early-stage investing space. Angel investors and private domestic capital is questioning the virtue of allocating capital to investments into businesses unless there is a clear path to IPO, thereby derailing the nascent angel investing momentum in India.

Angel groups and Angel investing in India

Post-2006, angel groups like ours, at Mumbai Angels, have gathered some momentum and, together with IAN and individuals acting as angel investors in all the key cities, have been taking the onus of risky equity investing at the early-stage to help spur this entrepreneurial promise that India holds. We’re all beginning to feel foolish for being “domestic” capital providers who fuel early-stage companies and take the most risk, only to pay the most tax if the companies that we back succeed and don’t go the IPO route in the process, i.e. they get merged / acquired prior to that (most funds and their Investors (LP’s) are happily not affected by all this DTC brouhaha since their capital gains proceeds ship to Mauritius tax-free).

It’s unfortunate that the VC / PE associations and funds who raise domestic capital have not raised enough awareness about this issue. (This is not to deny that there were perhaps a few petitions from groups like ours in response to the govt.’s request for opinion on the original DTC proposal who sought more favorable treatment for unlisted equity gains – went unheeded. However, the Long-term gains on Listed were promptly reduced to 0%, while Unlisted Equity Capital Gains were left to suffer a 30% marginal tax rate)

Entrepreneurs

A recent survey amongst students at one of the IITs suggested that over half the class wanted to start a business – isn’t that a fascinating contrast to even the 90’s? – when we were sending out these bright minds to another Mecca of entrepreneurship – the United States. From the momentum we’ve seen at angel groups and at start-up forums and college incubators, we’re on the verge of something big here, to put it mildly.

Fixing the DTC so as to not nip the interest from domestic capital in the ‘early stage investing bud’ is a critical component to this rosy future. The foundation has to be strong to deliver india’s potential as an economic powerhouse sustainably into 2025 and beyond, it’s not about simply creating short-term Sensex and Nifty peaks.

One could wax eloquent about how countries like UK and Canada and Israel go out of their way to provide sops – tax and otherwise – for start-up financing. That’s not the point here, nor is it about seeking an impossible tax exemption for all long-term equity gains made on startups. However, its important to bridge the current 30% divide between long-term capital gains treatment for unlisted equity and listed equity. It’s very unlikely that such companies can be flipped around in a year or less. So, we think it’s perfectly fine and fair to maintain a marginal income tax rate for short-term gains.

However, for long-term capital gains, its imperative to reduce the rate to not more than 10% greater than that applicable tax rate for listed equities, IF we can’t have the same tax status accorded to unlisted equities. Therefore, we need to strongly petition the tax authorities and finance ministry to heed to the call of start-up capital providers, and reduce long-term capital gains on unlisted equities to 10% in the proposed tax regime. Many an entrepreneurial dream needs to be funded by these home-grown angel investors – let’s not vanquish these dreams even before they can get started.

(With inputs from Mumbai Angels members – Anand Ladsariya, Ajit Surana and Anil Joshi)


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Direct Tax Code – Will it Derail the “Domestic” Angel Investing Movement

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