Is angel tax justified for Indian startups? Excessive official discretion is unreasonable

There is no reasonable way for a tax officer to know the fair price of a share.

26 April, 2023
The Print

Last week, the income tax department sent notices to startups asking why shares sold by them at a premium should be exempt from tax. The notices have been sent only to startups not registered with the government. The claim is that shares sold at a rate different from a “fair market valuation” must involve the generation and use of unaccounted money. The difference, or the premium, should therefore be treated as income and taxed. This issue, also known as the angel tax, has been in the news since 2018. At that time, the tax and late payment fees demands were sometimes more than the original funding amount. Earlier, the tax was levied only on investments by Indian residents, but the Finance Bill 2023 has extended its applicability to non-resident investors as well. This tax places unreasonable discretion in the hands of officials and is counter-productive to the goal of fostering a startup ecosystem.

What is fair market valuation?

The most obvious issue is arriving at a fair market valuation. Does every organisation have to be valued by everyone else in the same way?

Consider a founder who runs a tech startup that is asset-light. Her view is that the valuation of her company is Rs 100 crore. Most people may find this overvalued and choose not to invest. But she manages to find an investor who believes in her vision, is convinced about the valuation, and is willing to put up money for a piece of equity in the company. This seems like a transaction between two consenting adults.

The tax department, however, believes that there are only two ways to value a company: book value or the discounted cash flow method. If the valuation exceeds the one arrived at by a tax officer, who generally is not involved in the business, then foul play must be involved. From the administration’s perspective, differential viewpoints on valuations cannot exist. If, in subsequent years, the firm’s revenues do not bear out the projections made at the time of valuation, then there is even greater suspicion of the business.

It is possible that some startups or investors have been deliberately evading taxes. Others, however, could have made genuine mistakes in their valuations. It is also useful to remember that valuations are subjective. There is no one correct way. Some of the world’s biggest success stories have been made on the back of venture capitalists taking a bet on valuations of startups that may not conform to either of the methods. Many startups fail, but those that succeed often disrupt the status quo for the better. These organisations are treated with suspicion in India. The cost of capital for startups goes up, and they are effectively blocked from receiving funding even if both the donor and receiver are convinced of the soundness of the investment and are willing to take risks.

If a firm wants to get an exemption, it has to register with another government portal and undergo scrutiny by tax authorities. Considerable time and bandwidth are spent in obtaining this, or answering tax notices, or litigating with the government to justify the method of valuation; time and bandwidth that could have been more productively spent in running the business. The government’s own time and bandwidth will be better spent focusing on core public goods. It is not surprising that many startups prefer to register in jurisdictions such as Singapore, which has a less cumbersome tax regime.

Rule of law in tax administration

The angel tax issue is the most recent example of excessive discretion in the hands of officials. There is no reasonable way for a tax officer to know the fair price of a share. Firms already register with the Registrar of Companies (ROC). The case for additional registration on another portal and applying differential exemptions to those who don’t is weak. This is especially the case as the rules for obtaining exemption are so constricted in how they define “innovation”, that less than 2 per cent of startups have been granted the IT exemption. The discretionary power of officials discourages entrepreneurship and diminishes the foundations of a market economy.

There are two levers for taxation – income tax on individuals and corporate tax on the firm’s net revenue. There are live policy questions around the world on how to avoid double taxation with corporations, the tax income of multinational corporations, and how to treat the carried interest of PE/VC funds. The decision that tax policy in India takes on these questions has to ensure that taxes have as little a distortionary impact as possible. Both instruments of income tax and corporate tax are available for startups and their investors. With a rationalised income tax and corporate tax regime, there is no case for subjecting capital raised by startups to the vagaries of valuation methods decided by officials. High taxes and cumbersome administrative processes disincentivise investments, which is detrimental to economic growth.

SVB failure has lessons for India. Banks can shut down, deposit insurance needs reforms

The cost of merging a bad bank with a good one versus that of shutting them and paying off depositors needs to be made transparent. India may have to rethink its strategy.

12 April, 2023
The Print

It would have been hard for many to miss the words “deposit insurance” on the newsfeed last month. The US-based Silicon Valley Bank had caused it to shut down. The Federal Deposit Insurance Corporation or FDIC initially announced that deposits insured with the bank will be paid out. This has led to a discussion on the system of deposit insurance in India. Our experience suggests that much reform is required on pricing, as well as the process of payout. Depositors need to internalise that bank safety cannot be taken for granted.

Deposit insurance in India

Deposit insurance in India is managed by the Deposit Insurance and Credit Guarantee Corporation (DICGC). The DICGC insures all bank deposits up to a maximum amount of Rs 5 lakh. This implies that you will have access to deposits up to Rs 5 lakh if your bank fails. Any amount above it will be lost. Each bank has to pay an annual premium of 12 paise per Rs 100 of assessable deposits to the DICGC. That is, if a bank has accessible deposits of Rs 100 crore, then it will pay Rs 12 lakh as a premium. The DICGC will be solvent when insurance premiums are higher than the payouts.

There are two interesting features of such insurance in India. First, it is rarely used in the case of commercial banks. This is not because banks don’t fail, they are not immune. India’s response has been to merge the failing bank with a larger bank, often a Public Sector Bank (PSB), and kick the can down the road. There is no set process, the Reserve Bank of India takes a decision based on the circumstances. For example, Yes Bank was taken over by a group of banks led by the State Bank of India in 2020. Lakshmi Vilas Bank was merged with DBS Bank in 2020, Global Trust Bank was merged with Oriental Bank of Commerce in 2004, which along with United Bank of India was subsequently merged with Punjab National Bank in 2020. Vijaya Bank was merged with the Bank of Baroda in 2019.

As a result, the question of shutting the bank and paying out deposit insurance has not arisen. This is not to say that depositors have not had their accounts frozen. In the case of Yes Bank, withdrawals were limited to Rs 50,000 for a period of time. But if the strategy is to never let a commercial bank fail, then why collect insurance premiums from them?

Second, in the case of cooperative banks, it takes a long time for depositors to get their money. As of 2019, depositors have had to wait for an average of about six years to get their funds. When a bank fails, the liquidator of the bank is supposed to make a list of all the depositors, and hand it over to the DICGS. It is this process that causes the delay.

It imposes a huge cost, especially as depositors in cooperative banks are likely to be from low to middle-income groups. As an example, for the bank failures in 2017-18, if one assumes that the funds would have earned an interest of even 8 per cent, then depositors effectively suffered a 26 per cent loss. The process of deposit insurance payouts is not smooth, it imposes considerable uncertainty on the depositors.

Rethink bank failures

There is a larger philosophical question on deposit insurance. Does the existence of insurance make the banks reckless? Yes, unless insurance premiums are based on the risk of bank failure, and that central bank supervision flags off problems sooner rather than later. Does the current insurance pricing ensure that the DICGC fund will be able to honour the deposit insurance claims if these banks had instead been closed? It is unclear, and quite likely that if we ever shut down banks instead of merging them, premiums would have to be higher. The insurance premiums for commercial banks need to be calibrated in a way that payouts can be made in the event of their failure.

The areas of reform on deposit insurance are clear. The costs of closing a bank and paying off depositors versus the costs to the taxpayer of merging a bad bank with a good one need to be made transparent. This may make us rethink our strategy on bank failures. It is not unusual for banks to go bust, and a specialised resolution regime needs to be put in place. The government withdrew the Financial Resolution and Deposit Insurance Bill (FRDI) in 2018 and it may be time to bring it back.

In the meantime, depositors need to realise that banks are not always safe. There is a possibility that a bank failure may lead to the freezing of accounts for a while. If the bank is shut down, then payment of deposit insurance will only be upto the specified amount, and even that may take a long time to materialise. A strategy of diversifying deposits across multiple banks, and investing funds in alternative asset classes may be the path forward.