In a way, startups in India are paying for what parliamentarian YS Jagan Mohan Reddy did in 2012. In Bengaluru alone, scores of startups have been slapped with notices from the Income Tax department over the last year. Most of them are around a certain Section 56 (2) (viib) of the Income Tax Act, 1961. Startup folks know this section as “Angel Tax” but the IT department officers have a more characteristic name for it.
They call it the Jagan Reddy Section.
The moniker is a hat-tip to the events that unfolded after pharma companies in Hyderabad were given land at throwaway prices by the YS Rajashekar Reddy government between 2006 and 2011. And to make sure the companies returned the favour, the chief minister’s son, Jagan Reddy, created shell companies to receive kickbacks. The kickbacks were shown as investments, and the companies showed that they were investing in innovative new ideas.
India is one giant loophole. So it’s no surprise then that other Indian politicians and hoary folks quickly adopted this. Why pay tax when it is easier to create shell companies and bring in money as investments rather than revenue? While the beneficiaries are no longer liable to pay income tax, it helps the “investors” too as these shell companies can be shuttered in a couple of years and these investments can be written off as capital losses that can be set off against capital gains accruing from other sources. A double bluff if there ever was one.
To make sure that practices like this are nipped in the bud, the Income Tax department mounted an aggressive attack on companies that they believed were attempting this type of financial charade.
The problem, of course, is that there is no easy way to tell which company is legitimate and which is a shell. A simple rule of thumb that the tax authorities adopted, more as an exigency rather than as a thoughtful rubric, was that any private company that raised money from individual investors, rather than institutional investors, was subject to scrutiny.
Needless to say, this meant that several startups, especially those that received money from angel investors, were slapped with notices from the tax authorities. Under this section, it said companies should treat the difference in the funds raised at the actual value and the “fair market value” as “income from other sources”. And companies will have to pay a 30% tax on that income. Because startups receive funds from individual angels, this was dubbed as “angel tax” within the startup community.
And now, startups, even those that have shut down, have become unintended collateral damage. “We were slapped a penalty order of Rs 57.20 lakh by the IT department that said a major part of our angel fund was income,” said Rahul Vats, the co-founder of NexGear, which eventually shut down in 2017.
