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Startups

Speculation: SEBI Angel Fund Rules Could Help Ease Startup Tax

The Finance Minister had in his budget speech mentioned that:

SEBI will prescribe requirements for angel investor pools by which they can be registered as Category 1 AIF venture capital funds.

(Read: Startups in Budget 2013, a Mixed Bag)

CNBC has the news that SEBI might announce the requirements on July 25 (speculation):

In an exclusive to CNBC-TV18, sources say the Sebi board may announce rules for angel funds on June 25. Some of these rules may include angel fund investment to be limited to Rs 50 lakh- Rs 5 crore; angel funds to be invested in a company for at least three years; angel investors to invest in companies not older than three years; investee company to be unlisted and with a maximum turnover of Rs 25 crore; the investee company may not be related to a group with a revenue of greater than Rs 300 crore.

Sources add that the Sebi may also stipulate that the fund must not have any family connection with the investee company and that no angel fund scheme may have more than 49 investors.

Note: Cat 1 AIFs already have three sub-categories:

  • Venture Capital Funds
  • Social Funds
  • SME Funds

The Angel fund will have to be a separate sub-category.

Welcome, Tax-Pass Through

Note that AIF regulations means Category 1 funds, VC Sub-Category get a tax pass through, that is, any income made by fund investors will be their income, not that of the fund, which is beneficial for entities based in mauritius or singapore, who don’t pay any capital gains taxes. Cat-1 AIFs had certain restrictions, like Rs. 1 crore per investor,  which might be relaxed.

While this is a useful thing, it’s no different from the angel investing directly, which is what currently happens. 

An angel fund can help in the sense that it allows people to pool in cash and invest as one entity (for instance, 10 investors in one company can get a single represenation) but with the tax pass through each investor gets the tax benefits that he normally would if he invested on his own.

Fixing the Startup Tax, Somewhat

However some of the rules are designed to help avoid the Startup Tax problem. (Read the free Startup Tax e-Book) Angel investments in companies at a “premium” have been classified as “income” rather than an investment, unless the startup can explain to the tax authorities how such a premium is justified.

This has been brought in because it seems politicians are being bribed by corporates using the investment route. The corporate would invest a large sum of money into a small company owned by a politician, and take a very tiny stake in return. This is effectively a bribe since the money is not expected to be returned (no equity investment is), and the company will pay no tax on the investment (since it’s a capital flow, not income). See the Jagan-Srinivasan enquiry, or the Dasari Rao-Naveen Jindal allegations.

The tax authorities have plugged this loophole. A large investment at a premium will be called income unless the premium is justifiable, and if it’s income, the money will be taxed. In the process they make it very inconvenient for small startups who need capital and much of their value is based on future prospects not easily quantifiable.

In Budget 2012, the above problem was partially addressed; if a SEBI regulated AIF invested in a startup, it wouldn’t get hit with this Startup Tax. But the SEBI AIF rules made it difficult for small angels to start a fund – each fund needs at least 1 crore rupees per investor.

The above rules, I think, are designed to thwart the creation of entities by corporates to, again, bribe politicians. (If rules are lax, a corporate will create an AIF and then pay big money to a startup?) The AIF rules are already stringent – not more than 25% in one entity, minimum lock in, and so on. These rules can further contain the abuse.

The rule that the “group” of the company invested in should not have a turnover of Rs. 300 cr. or more, and there should be no family connection between the fund and the company; this help prevent one layer of abuse. And then, limiting the angel investment to Rs. 5 crore creates less chances of bribes (which would mostly exceed that amount by a multiple of 10).

AIFs currently can have upto 1,000 investors, but the limiting to 49 for angel funds is peculiar. However, the logic may still be related to abuse, to avoid the creation of a pool like Sahara or such.

Still Not Enough

Till the regulations come out, we’re not sure what will happen but many regulations need to be relaxed. For instance, one AIF regulation is that a fund should have a “key person” who has five years of experience in fund management with a professional qualification etc. Angels are typically not this profile, and this requirement must be relaxed.

The current requirement of Rs. 1 crore per investor is sure to be relaxed, but how much? I believe it should be taken down to Rs. 10 lakh, but I doubt that will happen – it is likely to be Rs. 50 lakh or something. Knowing how much angels pool in (5-10 lakhs each, typically) a large minimum would restrict their ability to create an AIF fund together.

June 25 will tell us more. CNBC’s sources haven’t always been accurate so the end-result may be quite different.