Sreejith Moolayil, founder of Pune-based start-up True Elements raised Rs 1.5 crore for his venture from an angel investor in year 2015. That would have been good news, except two years later, he received an order from the income tax department to pay Rs 40 lakh from that amount to the taxman as "angel tax".
He now worries the taxman might send him a notice to pay up tax on the amount he raised in the second round of funding for his start-up, but he is not alone in his concerns.
For start-up founders in India, December is a dreadful time of the year. Chasing the December 31 deadline to close pending cases, the taxman has been sending out notices and orders to start-up owners, demanding them to pay up what is called the Angel Tax.
The "angel tax", inserted to Section 56 of the Income Tax Act by the Finance Act of 2012 is tax that a start-up/company pays on the investment it has received from an angel investor above its "fair market valuation".
While taxing angel investment into start-ups itself is a move detrimental to the entrepreneurial spirit, since it is the first form of capital that flows into a budding start-up by an investor, the problem is complicated further by how a start-up is valued.
"A start-up can be valued in three ways. The Net Asset Value (NAV) method, the Discounted Cash Flows (DCF) method, and a third method in which a start-up can determine its own method for valuation", said Sachin Taparia, owner and chairman of Local Circles, a community of start-ups which works towards better regulations for entrepreneurs in the country.
Mr Taparia represented the issue of angel tax to Anil Aggarwal, Joint Secretary, Department of Industrial Policy and Promotion (DIPP) on Tuesday and has been asked to present a submission of their demands to the DIPP.
Union Minister for Commerce Suresh Prabhu also responded to appeals by a number of investors and industry leaders like Mohandas Pai, and Kiran Mazumdar Shaw, tweeting that the ministry has taken up the issue.
"What goes wrong is the government's assessing officer says we will reject the start-up's DCF method of valuation, and go for the NAV method, which significantly reduces the valuation of the start-up," Mr Taparia added.
The IT department taxes the difference in this value at 30.9 per cent, categorizing it as "income from other sources" under Section 56 of the Income Tax Act.
Entrepreneurs argue that the valuation, arrived at through a complicated and subjective process, should not be contested by the government, once it is agreed upon between the investor and the company.
"Anyone who has raised money before April 2018 is afraid of getting a notice from IT officer. What they're (the IT department) is looking at is if they've raised money at a premium to the share capital, and the premium amount is taxed. I received an order to pay 40 lakhs against the 1.5 crore angel investment my start up raised in 2015. We subsequently filed for an inter-ministerial board approval and are waiting for it. I am also afraid the subsequent amount of funding we raised in 2016-17 will be on the edge in the next six months - one year. That's the case with a lot of start-ups," said Mr Moolayil.
Mr Moolayil has been getting support from fellow start-up founders on Twitter to take up the issue to the DIPP.
Abey Zacharia, another start-up founder based in Bangalore who has received an order to pay angel tax worth Rs 24 lakh, points to a more fundamental problem, "The fundamental problem here is that the valuation agreed between the founder and the investor is not being agreed upon the IT department's assessing officer. It is best to leave this decision between the two parties as they know best about the market, the size of the opportunity, traction of the particular company at any given point in time etc. So it is very subjective decision. In fact even among investors, it is not common to have same value perception between start-ups."
"In our meeting today with DIPP, we outlined that it was extremely critical that CBDT clarifies for the income tax department that start-ups should be valued on the basis of the DCF method rather than the NAV method. What we also want is the CBDT to flag start-ups as a separate category, where before a notice is generated under Section 56, the flag is considered and the noticed is auto-nullified", Local Circle's Taparia, which represents 30-35,000 start-ups and SMEs said.
Mr Taparia will also put forward his submission in front of Suresh Prabhu on Wednesday.
A large number of the start-ups receiving notices now for assessment year 2017 or earlier, having raised investments in 2015 or 2016, and have by now shut down, and now feel harassed at demands of huge tax sums, which if not paid also invite hefty penalties. For many others, shifting to more start-up friendly countries such as Singapore appears to be a better business decision.