India today addressed a long-standing challenge that has been affecting the country’s booming startup ecosystem. As part of a raft of measures to boost overall economic growth from a five-year low, Finance Minister Nirmala Sitharaman said New Delhi is exempting startups from Section 56(2) — a provision more popularly known as an “angel tax” in the local income tax laws — that required startups to pay a certain tax if they received an investment at a rate higher than their “fair market valuation.”
Local tax authority in India does not recognize the discounted cash flow method that many investors use to value early-stage startups, and instead value the company for what it is worth currently, which as you can imagine, is very little. Investors assess a startup’s value based on what it could eventually become in the future.
Prior to today’s announcement, the government levied a 30% tax on affected startups. Sitharaman said any startup that is registered with the Department of Industrial Policy & Promotion, a government body, will be exempted from the angel tax. Those not registered will remain subjected to it, she said in a press conference Friday.
More than 24,000 startups are currently registered with the Department of Industrial Policy & Promotion. The law was originally introduced amid concerns that wealthy people could invest in bogus startups as a way to launder money.
“Angel tax was there to stop shell companies from creating capital from nowhere,” Piyush Goyal, a minister for commerce and industry as well as railways, said in a statement Friday.
The angel tax, which was introduced in 2012, impacted only the local investors, becoming a roadblock for many citizens from funding early-stage startups. The announcement today comes weeks after the Narendra Modi government said it would address this issue.
Many prominent investors, startup founders, analysts and other industry executives have long publicly criticized the angel tax, telling the government that it is severely hurting the health of the local ecosystem.
Anand Mahindra, chairman of Mahindra Group, said last year that the angel tax needs “immediate attention or else all chances of building a rival to Silicon Valley in India will be lost.”
Sreejith Moolayil, a founder of health food startup True Elements, said the existence of an angel tax would leave many entrepreneurs like him with no choice but to shut down their companies.
Late last year, India’s tax department sent a flurry of notices to startups demanding them to pay the angel tax on funds they received from individual investors. The notices sparked an uproar, with many calling it “harassment.”
“Hope this will address the concerns of DPIIT registered startups. The proposed cell should look into concerns of all startups including those who are already under notice,” said Ashish Aggarwal, who oversees Public Policy at industry body Nasscom, of today’s announcement.
The government will also set up a dedicated cell to address other tax problems that startups face, Sitharaman said. “A startup having any income-tax issue can approach the cell for quick resolution,” the ministry said in a statement.
Jayanth Kolla, founder and chief analyst at research firm Convergence Catalyst, told TechCrunch earlier that the angel tax was the primary reason early-stage startups in the nation were struggling to raise money from investors.
Even as Indian tech startups raised a record $10.5 billion in 2018, early-stage startups saw a decline in the number of deals they participated in and the amount of capital they received. Early-stage startups participated in 304 deals in 2018 and raised $916 million in funds last year, down from $988 million they raised from 380 rounds in 2017 and $1.096 billion they raised from 430 deals the year before, research firm Venture Intelligence told TechCrunch.
Sitharaman also announced the country was scrapping a recently introduced additional levy on foreign funds. The government would revoke the surcharge, which increased tax on foreign companies investing in India to over 40%, she said. She also promised to pay out all pending tax refunds owed to small and medium enterprises within 30 days. Companies have long complained that the tax authority takes too much time to refund the money owed to them.