The Government of India has been playing an active role in developing the startup ecosystem in the country. While various policy initiatives have helped boost the startup sector, they have also inhibited growth in many ways. In order to address some policy concerns and expand investment avenues, the Securities and Exchange Board of India, on March 1, 2019, approved the process for accreditation of investors on the newly renamed ‘Innovators Growth Platform’ on which startups may list their securities. In parallel, the Department for Promotion of Industry and Internal Trade has mooted the idea of utilising the concept of investor accreditation to legitimise investments in unlisted startups and, in particular, to ensure appropriate tax treatment for such investments. By introducing the concept of investor accreditation in the Indian startup sector, these policy pronouncements represent an important step in facilitating such investments. However, the manner of accreditation and its impact leave several key questions unanswered.
Listed Securities: Innovators Growth Platform
Securities regulators around the world bear the task of investor protection and impose considerable duties on issuer companies to make elaborate disclosures and comply with strict procedures while raising capital. However, leading jurisdictions around the world permit issuers to raise capital from specific types of investors, who are treated as accredited investors based on their wealth or sophistication, by following a much less onerous process. This is particularly attractive for startups who cannot afford the cost of a full-blown capital raising process.
SEBI’s recent efforts enable startups to raise capital from accredited investors in order to list on the IGP. SEBI’s announcement defines accredited investors as:
- individuals with total gross income of Rs 50 lakh annually and with a minimum liquid net worth of Rs 5 crore, or
- any body corporate with a net worth of Rs 25 crore.
In order to receive recognition as an accredited investor, an individual or body corporate must make an application to the stock exchanges or depositories in a manner that SEBI is to prescribe. This development will certainly introduce a defined legal structure for angel investments in India’s startups. It will allow accredited angel investors to participate by funding startups that list on the IGP.
However, SEBI’s approach towards investor accreditation is both over-inclusive and under-inclusive.
In most jurisdictions, individuals or corporates who satisfy the income and net worth requirements are considered accredited investors without the need for any express recognition or registration. It represents a self-certification mechanism of sorts. Some, like Singapore, have transitioned to an 'opt-in' approach whereby investors who satisfy the wealth requirements must positively consent to be treated as accredited investors. Failing such consent, they will continue to be treated as retail investors and subject to the full protection of securities laws. SEBI’s proposal takes it much further. Mere wealth or consent of the investor is insufficient. The stock exchanges or depositories must grant recognition based on an investor’s application. This introduces a level of bureaucracy that must avoid attracting inefficiencies such as delays and additional costs.
Such accreditation attracts criticism on the ground that wealth may not necessarily be a true measure of determining investor sophistication.
While it signifies the financial ability of the investor to bear a greater risk, it does not account for other factors such as financial literacy and experience.
The assumption that an individual or body corporate with greater wealth is able to manage financial risk better may not always be true. To that extent, such wealth-based accreditation carries limitations that investors and the startup community must not ignore.
Unlisted Securities: Transparency And Angel Tax
While investor accreditation has evolved as a measure of discerning sophisticated investors from other retail investors, the concept has assumed a different tone in India as a means of investor regulation. Although governments usually incentivise startups through various benevolent policies, including by offering tax incentives, the startup sector in India has been embroiled in the 'angel tax' controversy. The government has now mooted investor accreditation as a panacea to the tax ills that have plagued Indian startups.
Amendments introduced in 2012 to the Income Tax Act provide that where a company receives investments from a domestic investor at a consideration that exceeds the fair market of the shares as determined by the tax department, the excess is treated as income in the hands of the issuer company and hence taxable. However, investments from certain defined categories of investors such as venture capital funds are exempt from the tax.
Intriguingly, this provision was introduced to prevent money laundering, conversion of black money into white and other illegitimate financial activity. It was never intended to ensnare genuine commercial transactions such as angel investments into startups.
However, a recent spate of tax claims made by the tax department against a large number of startups receiving angel investments, and the consequent backlash from the industry and its doyens, brought the issue to the limelight.
There has been welcome coordination between the DPIIT and the tax authorities to promptly stem the tide of tax claims and associated discontents from startups. The DPIIT, on February 19, 2019, fine-tuned the process by which it granted recognition to startups by specifying conditions that such entities need to comply with. Accordingly, the Central Board of Direct Taxes soon thereafter clarified that startups that fulfil the conditions stipulated by the DPIIT will not be subject to the angel tax.
These efforts broadly seem to be in the nature of interim measures. They largely govern the startup, i.e., the issuer entity, and do not encompass entities that are investors in the startups.
At the same time, DPIIT officials have announced that they are exploring the possibility of focusing on the investor side of the equation and to explore accreditation as a sustainable solution to the angel tax controversy. While this is an understandable shift, one must guard against inadvertent challenges that may emerge.
The Way Forward
As seen earlier, the concept of investor accreditation was introduced largely as an investor protection measure. SEBI’s approach towards recognising this for the IGP is consistent with this approach. However, the DPIIT’s steps, as well as the angel tax as it was originally envisaged, are aimed fundamentally at ensuring the legitimacy of the investor and the source of funds from which the investment is being made. The goals of the two approaches are somewhat different. In using the same tool, i.e. that of accreditation, to address different concerns, one must not lose track of the divergence of objectives in the process.
Excessive regulation of investors and imposing disproportionately high burdens on investors would hamper rather than nurture the startup sector.
As the angel tax controversy demonstrates, the lack of coordination among various regulators can have a debilitating effect on the startup sector. There is a need for greater harmonisation. At present, SEBI has already established an investor accreditation mechanism, although it is specific for companies listed on the IGP. The DPIIT would do well to harmonise its requirement for unlisted companies with those that SEBI has set out, so that investors are not compelled to resort to multiple accreditation processes for different purposes.
In all, investor accreditation is a useful tool that has been tried and tested in leading jurisdictions, but its success would depend on the manner in which Indian regulators deploy it. Disparate regulatory requirements, inefficient bureaucratic processes, and intrusive requirements for accreditation are recipes for failure. A careful balance between the advancement of the startup ecosystem on the one hand and investor protection and investor transparency, on the other hand, must dictate the design of accreditation.
Umakanth Varottil is an Associate Professor of Law at the National University of Singapore. He specialises in company law, corporate governance and mergers and acquisitions.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.
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