Angel Tax Issue

turning money black

 

The angel tax problem is a manifestation of information asymmetry and can be dealt with through risk insurance, post-facto assessment and third party validation

 

Bonafide Startup

"True dot AI" raises INR 100 mn at a valuation of INR 500 mn (20% stake)
Company characteristics
o    Declared domain: Artificial Intelligence
o    Assets as per balance sheet: Nil
o    3 employees other than founders 
o    No revenue projected for the next 18 months
o    Company Age: 8 months since incorporation
o    Merchant banker certificate: Approves based on assumptions


Malafide Startup

Pratham owes Aditya INR 100 mn for an illegal property transaction. If Pratham pays Aditya, Aditya will have to pay 30% tax on it.
Aditya creates a company: "False dot AI" and sells 20% shares to Pratham for INR 100 mn. 
Company characteristics
o    Declared domain: Artificial Intelligence
o    3 employees other than founders 
o    Assets as per balance sheet: Nil
o    No revenue projected for the next 18 months
o    Company Age: 8 months since incorporation
o    Merchant banker certificate: Approves based on assumptions

 

The two transactions look very similar from the outside. Tax is evaded in the second case by disguising the payment as an investment. The tax department would like to tax all cases like the second one. 

This is a classic example of Akerlof Market for Lemons. In case the tax on such investments is removed, it would incentivise all income to be routed through this route. It would start with illegitimate income and encompass property transactions and other sales of capital goods. All employees with enough bargaining power would insist that the company buy out equity in their shell companies instead of paying them a salary, thereby enjoying 30% extra.
Over time this exemption would have to go and all such transactions would have to be taxed. This way there is no incentive for anyone to route transactions through this route. All investments that startup gets would be taxed at a flat rate. 
In terms of Game Theory, they would be at par. It would not impact startups differently but everyone would be worse off. This is because all startups would get 70% of the investment. A standardized levy creates a deadweight loss because suppliers of service get that much less for each unit sold.

 

The answer to information asymmetry is information symmetry. This can be achieved in the following ways:
1.    Risk insurance: This would reduce the impact of the asymmetry. In case it doesn’t matter if a decision is flawed, the advantage of asymmetry would erode. Insurance also brings with it increased awareness and formalisation of requirements.
2.    Transparency: Increased transparency decreases information asymmetry. This entails higher disclosure requirements for the seller.
3.    Testing/Verification: If the product can be tested by the buyer, it would increase the information. This is possible ex-ante as well as ex-post.
4.    Third party validation: In case an independent party is willing to certify as to the disclosed information, it helps to reduce the asymmetry. In case the independent party has credibility, it lends credence to the available information.

 

In the used car market, this is done in the following ways:
1.    Risk insurance: Apart from insurance, this is done through money-back guarantee schemes
2.    Transparency: On-board devices in vehicles and other means to ascertain vehicle history.
3.    Testing/Verification: Car manufacturers purchase cars and resell them with their credibility. Maruti True Value claims to conduct 376 tests.
4.    Third Party Verification: Companies like Cars24 and Cars Dekho offer verification, testing, warranty and their credibility.

  
Applying this to the angel tax problem, we have 
1.    Risk insurance: 
     a.    In case the income tax department fails to recognize a fraudulent transaction, they can send a notice up to eight years after the investment year.
     b.    In case a startup receives a notice, it should be supported through consultants and lawyers, and there should be no monetary liability.
2.    Transparency: This is happening post facto where information is being sought from startups relating to the transaction, basis for valuation and source of funds. This process can be improved.
3.    Testing/Verification: The tax department can understand the nature of the transaction once the money is used.
4.    Third Party validation: DPIIT evaluates applications for exemption from section 56 of Income Tax Act, 1962.

 

In case you have any suggestions as to how the problem of information asymmetry can be solved in this case, would be great to share them. You can also visit our resources section to know more about taxation in India.