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FAQ on the Startup Tax

Lots of questions have come in on the Startup tax post (Angel Investors Beware: Funding Startups Could be Classified as Income) and I’ve tried to address them here. The idea, for those who don’t have the time, is that investments in any company must now be “justified” to a tax officer, unless they are by a VC fund. If the tax officer finds that the money was more than “fair market value” using a set of criteria that are irrelevant to most tech startups today (valuing physical assets etc.), then whatever is extra will be recognised as “income” on the startup’s books, meaning they have to pay tax on it.

It’s Only Active In 2013-14!

The clause applies to “Assessment Year" 2013-14. In that year, you file taxes for 2012-13. It’s one of those strange budget things, but when they say assessment year they mean it applies to the year preceding it.

See the memorandum and search for Section 56, this clause is at the end:

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.

The Clause applies to investment from a “Person”. Angels can create a company and invest.

Under Section 2 of the IT Act (“Definitions”) :

“person” includes—

(i) an individual,

(ii) a Hindu undivided family,

(iii) a company,

(iv) a firm,

(v) an association of persons or a body of individuals, whether incorporated or not,

(vi) a local authority, and

(vii) every artificial juridical person, not falling within any of the preceding sub-clauses.

The last entry could even include an LLP (which is currently not listed specifically). But effectively this blocks any form of angel investment whether directly or through an investment vehicle (other than a VC fund, of course).

Startups Will Spend All That Money, So No Profit To Pay Tax On!

If a startup gets investment it will use most of it up in the year. Even if the tax department classifies the money as income, it will be offset with the expenses thus, no tax will apply.

Two points to note here. First, these “loss” that startups incur in the first few years are offset by profits in subsequent years (losses are “carried forward”). This is a tax element that is legitimate; so if you make a profit in subsequent years, you don’t have to pay the government any tax until you’ve covered up your earlier losses. Effectively, by treating investment as income, the startup tax will eat into future profits. (Loosely speaking, losses carried forward are an “asset”) Either you will pay the tax todaa, or tomorrow; it’s a tax all the same.

Second, note that not all expenses are written off in the first year. Yes, some are, like salaries. But if you buy assets – tables, chairs, a UPS, equipment, machinery and such – these are “depreciated” over time (a different time for each kind of asset).

In a simple scenario where you get Rs. 10 lakhs and use it to invest in equipment with a depreciation rate of 10% a year, the total ‘expense’ in the first year is Rs. 1 lakh. If the investment is treated as income, you have 10 lakhs of income with 1 lakh expense; so your “profit” is Rs. 9 lakhs, on which tax applies. (Remember, at this point you don’t even have money as you used all that 10 lakhs to buy equipment)

But This Will Curb Black Money?

If anyone is aware of the system of black money, it is the tax department. Black money is either money on which you don’t pay tax, or money obtained through corruption. (or both) If an investor legitimately invests in a company, using a cheque from a bank account, is the “black” money the fact that his money is tainted? In which case, use the “Section 68 amendment” to explain the investor’s sources instead; this fair-market-value clause is unnecessary. (Read: Private Cos: Investors Must Reveal Source Of Funds)

The other thing is that this clause does not apply if your investor is a non-resident. Most people know how easy it is to route money abroad and then bring it back as “investment”; if that is all it takes, how can it prevent black money?

Can’t Startups or Angels go Abroad?

Not every investor can, and it’s expensive, through it seems the Singapore route may not be. However, do we really want to be telling our startups that we can’t invest in them unless we go abroad? And what’s to stop the tax department from easily including foreign investment in the clause?

Going abroad has other ramifications. Wealth held abroad is subject to wealth tax. From this budget, you have to report in more detail on your holdings abroad; if they find out you’ve created a company abroad to invest in Indian companies, will they just ignore it? The General Anti Avoidance Rules (GAAR) will likely be used to squeeze the life out of the investor.

Startups going abroad is more painful. You hire here, you work here, you know the market here. How do you service that market from abroad? If you sell locally, you need local presence. While some companies will be able to go abroad, create an entity, and then come back create an Indian subsidiary, this avenue is fraught with risk and expense.

I hate to think of “going abroad” as a solution. In the 90s, I refused because I wanted to start a company. In the 2010’s I should go abroad if I want to start a company? Jeez.


If you have more questions, please comment here. I’ll update this page.

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