How the angel tax may force founders to seek indemnities from investors about the source of their investment.
Many a funding round has been delayed, if not derailed, by a simple term: indemnity. An indemnity is a contractual arrangement wherein one party (the indemnifier) agrees to compensate any loss suffered (indemnify) by the indemnity holder for any acts committed by the indemnifier.
A simple enough concept to comprehend, but the indemnity clause always sees lawyers from both sides engage in a game of verbal Jenga – adding layer upon layer of complexity in the form of a de minimis, caps, carve-outs, and buckets until it resembles a veritable Tower of Babel.
But one thread unites all such clauses: that the founder and the company indemnify the investors, not vice versa.
Angel tax dilemma
However, the angel tax threatens this delicate balance.
Oceans of ink have been spilled to slay this demon plaguing Indian startups, which seeks to tax a capital receipt as income.
Section 56(2)(viib), or the “angel tax” section, was introduced in 2012 by the UPA government under “Measures to prevent generation and circulation of unaccounted money” (cited from the Budget 2012 memo).
Yet the intent of taxing unaccounted money in the form of share premium has given way to taxing all share premium as income, whether accounted for or not. But within those measures lies something more pernicious and sinister: Section 68.
Section 68 is directly linked to section 56(2)(viib) and seeks to tax unexplained cash credits as income in the hands of the company. The rider is that the explanation given by the company isn’t enough – the resident investor also needs to offer an explanation of the source and nature of the funds and the explanation needs to be accepted by the Assessing Officer.
Instead of directly reaching out to the investors, the taxman makes the startup the middleman and forces them to procure the necessary documents, as evidenced by this extract from a scrutiny notice.
It thankfully also spells out what “credible evidence” constitutes:
Regardless of the fact that income-tax returns are available with the tax department, no investor will share such sensitive details with the company and that the law states that the assessing officer needs to seek these documents from the investor, this is the harassment that startups face for taking money from Indian investors.
Instead of penalising the source of the “unaccounted funds”, the taxman penalises the companies.
If this twin test isn’t met or the assessing officer isn’t satisfied by the explanation, the company will be taxed at a whopping 83.25 percent under section 115BBE.
This oppressive tax rate, meant to deter companies from laundering unaccounted funds via high premia, penalises the application of the funds instead of the source.
Thanks to the law, the company suffers a loss due to the actions of the party that it relied on, for no fault of the company. Seems unfair?
Job for indemnity
This looks like a job for indemnity!
Just as investors seek indemnities for any losses suffered by the investor due to the action of the company or wilful misrepresentation, startups should seek indemnities from their investors before taking their money. This indemnity should cover any damage suffered by the company on account of the investor’s money being successfully persecuted under Section 68, due to its being from unaccounted sources.
The law needs to be changed to leverage other measures that have come in place since 2012 and rectify the abject discrimination faced by domestic investors (note that the angel tax and Section 68 don’t apply to foreign investors).
But this representation given by investors that their investment comes from accounted sources and that they will indemnify the company for any loss suffered by it due to this statement being proven false is an important measure startups and founders can take to protect themselves from damages and losses for no fault of their own.
In life, the only guarantees are death and taxes. For everything else, there’s indemnity.