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Startups

Jagan-Srinivasan Enquiry Explains the Startup Tax

When the CBI investigated BCCI Chief N. Srinivasan’s company, India Cements, they seem to have uncovered why the “Startup Tax” was introduced in the budget. (Read Full Set of Posts) The company invested in companies owned by Jagan Reddy, son of the late YS Rajasekhara Reddy, who was the Chief Minister of Andhra Pradesh, in a way that the CBI says was a disguised bribe. From Firstpost:

According to the FIR, India Cements made following investments in Jagan Reddy’s Companies:

– Rs 5 crore in Carmel Asia Holding Pvt Ltd, one of the 36 companies created by Jagan Mohan Reddy. He paid Rs 252 per share, while the promoters and group companies had paid only Rs 10 per share.

– Rs 15 crore in Raghuram Cements Ltd (now called Bharathi Cements) purchasing 12,50,000 shares at a premium of Rs 110 in 2007.

– Rs 40 crore in Jagathi Publications, which owns Sakshi TV and newspapers.

And in return, according to the FIR, Jagan Reddy’s father YSR Reddy rewarded Srinivasan’s India Cements with the renewal of a land lease in Kadapa district on 11 July 2008. Srinivasan’s cement company was permitted to draw upto 10 lakh gallons of water from Krishna river by a government order on 22 July 2008 and 13 million cubic feet of water from Kagna river through a government order on 12 September 2009.

“It is alleged that the promoters and group companies of Jagan Mohan Reddy had subscribed to the capital at par whereas all other shareholders had subscribed to the shares at a premium of Rs 252 per share in Carmel Asia Holdings as an alleged quid pro quo for the benefits which they got from the Andhra government,’’ the FIR says.

From MoneyLife:

Nimmagadda Prasad alias Matrix Prasad, touted as entrepreneur with a golden touch in the pharma industry, is also alleged to have followed the YSR/Jagan model of investing in their companies in return for getting access to various resources. Prasad has been charged with investingRs100 crore in Jagati Publications that publishes Sakshi Telugu daily, besides putting in another Rs244 crore in Bharati Cements and Rs200 crore in Carmel Asia, all floated allegedly by Jagan.

In return, Jagan’s father, late YS Rajasekhara Reddy, allegedly allotted 15,000 acres of land in Prakasam and Guntur districts to Matrix Enport, the company owned by Prasad, for development of the Vadarevu-Nizampatnam Port and Industrial Corridor. Till date the project, initiated in 2007, has not made any progress.

This is important because this is why they decided to have an investor “explain” when he invests at a “premium” into a company. But why didn’t Jagan’s company just bill Mr. India Cements for some random service like “consulting”?

Because a service attracts service tax. Selling a product attracts VAT. And then, the receiving company has to pay income tax on the money it gets. The bribe taker would have to pay, for Rs. 100 received:

a) Rs. 10-12 in service tax

b) 30% of the remaining as income tax (since it’s a bribe they won’t even spend it)

The other method of taking it as investment instead is far more “tax effective”, with India Cements buying a tiny stake for a large sum. It’s not a service, so no service tax. There’s no income to the company – only an investment. So no income tax.

This is why they have created the new tax structure, which as a by-product kills all other legit startups as well.

I recall that I had been told this: even Reliance Infra had purchased shares into Reliance Power at a premium, while the promoter had bought shares at a far lower value a few months earlier.

The current solution – of limiting such investments to Rs. 5 crore – will not help much. The Jagan types will simply float more companies instead. But at least it will be noticed that a large entity is investing exactly 5 cr. in a big number of tiny shell companies, and then justice can happen.

What we need is a law that helps catch the Jagan types but still allow startups the ability to raise money from non-VC investors. But in the light of the massive fraud in the Jagan-Srinivasan case, we might not get an easy way out.

What to do then? Simple: don’t take money as equity. Take money as convertible debt instead. Debt reflects on company books and is likely to be questioned easily in cases like Jagan’s companies, while genuine investments are explained easily. And when the time comes to convert, you can convert it and then be able to explain that time’s valuation better.

(Note: This is not to justify the startup tax, but to state that if we want to repeal it, we need to address abuse cases like the case above.)