Social Empowerment

India’s startup ecosystem

Apart from job creation — or the lack thereof — taking center stage as an electoral issue in the run-up to the impending Lok Sabha polls, if India doesn’t create enough jobs for its young people, its much-touted demographic dividend will become a demographic disaster.

And global data is conclusive that neither governments nor big business can make this happen. Based on data since 1977, a Kauffman Foundation study by Tim Kane, ‘The Importance of Startups in Job Creation and Job Destruction’, found that, except for seven years in between, all net new job growth in the US came from startups.

GoI’s recognition of startups as a key engine of job creation and economic growth was, therefore, very welcome. Prime Minister Narendra Modi, the department of industrial policy and promotion (Dipp), NITI Aayog and even the Securities and Exchange Board of India (Sebi) have led from the front with a slew of measures to create an enabling environment for startups. This has led to India becoming the third-largest entrepreneurial hub with some 26,000 startups.

Besides creating lakhs of jobs and attracting billions of dollars of global capital, these startups are also creating innovative solutions for India’s many challenges in affordable healthcare, education, agricultural productivity, clean energy, water, and sanitation.

But the devil lurking in what could have been a garden of Eden is the ‘angel tax’, which now threatens to undo all the good work done so far. Introduced in 2012, Section 56(2)(viib) of the Income-Tax Act taxes any investments made by an Indian entity in an unlisted Indian company above fair market value as income.

Thereby, India has the dubious distinction of being the only country to do so. Surprisingly, investments by overseas entities are exempt. Tax Hounds in Pursuit Hundreds of I-T notices have gone out to startups already battling the twin challenges of global competition and fund availability.

Some prolific and iconic angel investors have received scores of I-T notices as well, asking not just for the permanent account number (PAN) but also the detailed computation of income, full-year bank statements for all accounts, and various other documents normally provided to an assessing officer (AO) for scrutiny. Rather than face such harassment for Rs 10-20 lakh investment in a startup, many angel investors have stopped investing.

Several are locating abroad to raise monies from the same investors without this tax. This has tragic consequences for India as angel investors are the first ‘non-family and friends’ investment in a startup and provide the valuable mentoring and market access that often makes the difference between success and failure.

In the United States, in a typical year, venture capitalists (VCs) invest around $25 billion in 5,000 companies, while angels invest about $26 billion in 50,000 companies, creating the ideal entrepreneurial pyramid where 1 in 10 companies make it to the next level, but needs 10 times the money.

The problem with an ‘angel tax’ is that startups generally have no profits, often no revenues and virtually no assets. Savvy angel investors value them based on the deemed value of the idea, the possible market size, the quality of the founders/team and their passion. Rarely do two investors agree on a valuation. In this world, any prescriptive valuation norm is pointless. AOs, ill-equipped to value companies with the negligible/negative book, inevitably tax the investment as income.

This makes Section 56 of the I-T Act the most entrepreneur-unfriendly legislation in the world, forcing startups to raise 50% more money than they need (to pay 33% tax) and suffer unnecessary excessive dilution. And all this for what? Angel investments, while creating the nurseries of thousands of startups that VCs and global corporates build into Flipkarts, Olas, and Paytms, are barely a few hundred crores. Angel tax collections, if any, would be hard. Rs 20-30 crore, far less than the administrative and litigation costs incurred by GoI and the startups. Dipp must be complimented for tirelessly batting for startups.

The latest move by commerce minister Suresh Prabhu taking up the issue with the finance ministry to shield startups from angel tax is heartening. But the real solution is to relook at Section 56.

Ostensibly, the amendment was put in place as some politicians were starting companies and raising money at a premium from people who benefited from their ‘largesse’. But illegal payments cannot be prevented using tax laws, as the corrupt will find other ways to pay. It is anti-corruption laws that need tackling, not the payment mechanism. Section 56 is flawed legislation as it seeks to ‘lazily’ tax — and, thereby, legitimize —an illegal transaction rather than make prosecutions.

Also, by being applied inappropriately and indiscriminately to genuine startups, it is causing unintended collateral damage to India’s entrepreneurial ecosystem. The Central Board of Direct Taxes (CBDT) must either scrap Section 56 of the I-T Act or redraft it to exclude genuine startups and angel investors.

It would be tragic if, for a few paise and a lack of vision, India misses the best window it has had in a very, very long time to return having 25% of global GDP.

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