Contributed by Snigdha Ghose

Introduction

The Indian start-up ecosystem witnessed a significant policy shift with the abolition of the long-standing angel tax under Section 56(2)(vii b) of the Income Tax Act. Finance Minister Nirmala Sitharaman’s announcement during the Union Budget for 2024-25 to abolish this tax is poised to bolster entrepreneurial spirit, support innovation, and rejuvenate investor confidence. However, while this move is largely celebrated, it also raises critical questions about its impact on bureaucratic red tape and the persisting challenges within the start-up landscape.

Historical Context and Criticisms

Introduced in 2012 by then Finance Minister Pranab Mukherjee, the angel tax was designed to curb money laundering practices by taxing funds raised by start-ups from angel investors when these funds exceeded the Fair Market Value (FMV) of the company. With a tax rate of around 30.9%, this measure aimed to combat the misuse of inflated valuations often associated with shell companies and fake start-ups, which were exploiting loopholes to launder money.

Despite its intended purpose, the angel tax faced severe criticism for stifling innovation and deterring fundraising. Start-ups struggled to justify their valuations, leading to significant tax liabilities that hindered their growth and discouraged investment. The Angels and non-structured groups struggled to invest due to discrepancies between FMV and agreed valuations. The resultant complexities and uncertainties caused many top entrepreneurs to relocate to more start-up-friendly environments like Singapore, Dubai, and North America.

A relief in this context was brought about in 2019 by exempting start-ups from the draconian tax when the total value for the deal is less than INR 25 Cr. However, domestic non-AIFs investing in Indian start-ups were still required to pay taxes on their deals. The Finance Bill, 2023 includes a modification that affects international investors by removing their exemption. Consequently, any offshore fund investing in India will be affected. The new proposal aims to eliminate the exemption for overseas money and enhance the monitoring of transactions involving Indian persons acting as Limited Partners (LPs) in blind pool foreign funds. However, this proposal had its own implications whereby, instead of global investors initiating India-based Alternative Investment Funds (AIFs), they might exert influence on Indian entrepreneurs and start-ups to relocate abroad and participate in those organizations.

The Abolition and Its Implications

Finance Minister Sitharaman’s decision to abolish the angel tax marks a pivotal change aimed at revitalizing the start-up ecosystem. In 2023, start-up funding had plummeted to $11.3 billion from $42 billion in FY 2022, highlighting the urgent need for reform. By eliminating a tax that is imposed up to 30% on investments, the government aims to boost funding opportunities and attract more investors.

Brijesh Damodaran, Partner at Auxano Capital, in order to describe the nature of levying angel tax, used the phrase “Sword of Damocles” over start-ups, noting that its abolition provides much-needed certainty to promoters and investors. The move is expected to enhance investor confidence and simplify the investment landscape, addressing one layer of bureaucratic complexity that has long plagued start-ups.

Persisting Challenges

However, while the abolition of the angel tax removes a significant barrier, it does not entirely eliminate bureaucratic red tape. Start-ups in India continue to face an array of regulatory and compliance challenges that complicate their operations. The increase in Long Term Capital Gains (LTCG) tax to 12.5% further sends mixed signals about the government’s commitment to fostering a conducive environment for start-ups. It is known that no other country imposes such a tax, underscoring its redundancy and the minimal tax revenues collected from start-ups since its introduction. The challenge remains in aligning FMV with agreed valuations, a discrepancy that has historically deterred investments from angels and non-structured groups.

Additionally, despite the removal of the angel tax, start-ups still grapple with bureaucratic red tape that can stifle their innovative nature. The process of regulatory compliance, obtaining necessary approvals, and navigating the complex tax regime remains cumbersome. The absence of a robust single-window clearance system leads to duplication of efforts and delays. The complex processes in tax laws that start-ups have to navigate include GST and income tax. Protecting intellectual property is also problematic due to the lengthy and complicated patent filing process and enforcement issues stemming from slow judicial processes and limited awareness among law enforcement. Furthermore, inadequate infrastructure, such as unreliable internet connectivity, power supply issues, and poor transportation networks, can also act as significant hurdles.

Recommendations

In order to tackle these issues, the following can help:

1. Firstly, the creation of a centralized platform for start-ups to obtain all necessary approvals and licenses.

2.  Reducing the mandatory filings and simplifying the compliance procedures by moving to digital platforms, especially for early start-up stages.

3. Providing clarity in tax filing portals in light of start-up regimes and making it consistent across the country (for the most part).

4. Provision to offer tax incentives like more tax holidays to budding start-ups, can also initiate greater investment.

5. Expansion of credit guarantee schemes to reduce the risk for banks and financial institutions, making it easier for start-ups to access credit.

6. Organize awareness campaigns and offer support services to assist start-ups in comprehending and navigating patent filing and other related procedures.

7. Establish and promote start-up hubs in various regions to facilitate access to resources, mentorship, and networking opportunities.

8. Incorporate entrepreneurship education into the academic curriculum of schools and colleges to cultivate a mindset of creativity and entrepreneurship starting at a young age. Offering certificate courses can help.

9. Implement methods to systematically collect input from start-ups regarding the difficulties they encounter and utilize this feedback to consistently enhance policies and support system.

10. Advocating for more radical transparency from the legislative end could also be a boon for the start-up industry.

Conclusion

Though this remarkable decision comes as a beacon of hope to the start-up industry in India, the journey towards a robust and dynamic start-up ecosystem in India is far from over. While the removal of the angel tax marks significant progress, sustained efforts are needed to overcome the persisting challenges of red tape bureaucracy and create a fertile ground for start-ups to thrive and drive the country’s economic growth.