Wrath of Angel Tax for Start Ups

Vinesh Kriplani & Harshita Jain

Start-Up India is one of the top initiatives of the Indian Government which aims at building a strong environment favourable for the growth of start-up businesses. India currently has close to 39,000 active start-ups and has raised nearly 38.5 billion dollars from January 2014 to September 2018. The Angel Tax controversy has been a dampener on the start-up India initiative. Despite various measures taken by Department of Industrial Policy and Promotion (DIPP) and CBDT till date, the issue is far from being resolved and calls for drastic steps from the Government to uphold its vision of Start-Up India.

India is the only country that discriminates its own citizens from investing in Indian start-ups as against Foreign Investors. Since the provisions of Section 56(2)(viib) do not apply to start-ups raising funds from non-resident taxpayers (i.e. foreign investors), start-ups raising funds from domestic/resident taxpayers are placed at an obvious disadvantage. Due to this, Indian investors refrain from investing in Indian start-ups with the fear of potentially attracting Section 56(2)(viib).

The concept of “Angel Tax” possibly does not exist anywhere else in the world. High share premium is an outcome of valuation and has not been flagged as an issue of concern anywhere else in the world. Instead of taxing such receipts, start-up investments are incentivised in many countries. Also, there is typically no concept of valuing start-ups, except in case of transfers or exits.

Understanding Section 56(2)(viib):

The Central Government has been implementing various initiatives to curb the circulation of black money. One of the initiatives taken by the Central Government is the introduction of section 56(2)(viib) to the Income Tax Act, 1961 via Finance Act, 2012. The main objective of introducing this Section, as stated by the Hon’ble FM in his budget speech, was to discourage the generation and use of unaccounted money through subscription of shares by a resident person, of a closely held company, at a value which is higher than the Fair Market Value (FMV) of shares of such company. However, the provision has led to several unwanted consequences and controversies.

By virtue of 56(2)(viib), the aggregate consideration received by a closely held company for issue of shares that exceeds the FMV of such shares shall be deemed to be the income of the closely held company under Income from Other Sources for the relevant Financial Year. However, the provisions of Section 56(2)(viib) do not apply if the shares have been issued to:

1.  Non-resident Individuals or Corporates;
2. Venture Capital Undertakings or a Venture Capital Company; and
3. A class or classes of persons as may be notified by the Central Government.

Tax under Section 56(2)(viib), which is also referred to as “Angel Tax” has become a burning issue in the recent times. Start-ups are receiving notices for issuing shares at a high premium. In this article, we will take a closer look at the changes that have taken place since the time this section was introduced. With a view to provide relief to the funds raised by genuine start-ups, the Ministry of Finance exempted “Classes of persons” investing in start-ups from the Angel Tax.

Analysing the Notifications:

1. G.S.R. 501(E) dated 23^rd May 2017:

Under this notification, an entity shall be considered as an Eligible start-up if:

1. if it is incorporated as a private limited company or registered as a partnership firm or a limited liability partnership in India; and
2. up to seven years from the date of its incorporation/ registration; however, in the case of start-ups in the biotechnology sector, the period shall be up to ten years from the date of its incorporation/registration; and
3. if its turnover for any of the financial years since incorporation/ registration has not exceeded Rupees 25 crores; and
4. if it is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.

However, such entity shall not be formed by splitting up or reconstruction of a business already in existence.

For an entity to be recognised as an Eligible Start-up, an application has to be made to the Inter-Ministerial Board (IMB) on a Portal set up by the DIPP.

• G.S.R. 364(E) dated 11^th April 2018 and G.S.R. 34(E) dated 16^th January 2019:

The basic definition of a start-up remains the same as defined in the Notification G.S.R. 501(E) above. An application needs to be made on a portal set up by the DIPP to IMB to be recognised as an Eligible start-up.

A start-up being a Private Limited Company and in conformity with the definition of a “Start-up” shall be eligible to apply for approval for the purposes of Section 56(2)(viib) if the following conditions are fulfilled:

1. the aggregate amount of paid up share capital and share premium of the start-up after the proposed issue of shares does not exceed Rs. 10 crores,
2. the investor/ proposed investor, who proposed to subscribe to the issue of shares of the start-up (“investor”) has –
3. (a) returned income of Rs. 50 lakh or more for the financial year preceding the year of investment/proposed investment;
   and

(b) net worth exceeding Rs. 2 crore or the amount of investment made/proposed to be made in the start-up, whichever is higher, as on the last date of the financial year preceding the year of investment/proposed investment; and

• the start-up has obtained a report from a merchant banker specifying the FMV of shares in accordance with Rule 11UA of the Income-tax Rules, 1962. However, the requirement to have a fair market valuation certificate from a merchant banker is done away with, vide Notification G.S.R. 34(E) dated 16^th January 2019. The application only seeks a justification for the valuation of shares

Notification G.S.R. 34(E) dated 16^th January 2019 requires the application for approval to be made to the DIPP. This application shall be transmitted from the DIPP to the CBDT, which shall accept or reject the application within a period of 45 days.

Actions taken by Tax Authorities:

Despite these notifications, start-ups are still facing a lot of issues. The CBDT had to be brought into play since there were significant delays by the IMB in granting approval to start-ups after making the prescribed application. Out of total applications received, approx 14,000 have been recognised as start-ups by DIPP and approx 91 start-ups have been approved by the IMB for availing the tax benefits. Nearly 2,600 start-ups have received “Angel Tax” notices for the monies raised by them in Financial Year 2015-16 alone, in spite of receiving such amounts through banking channels and after obtaining a valid valuation report as per prescribed rules using DCF Method.

There are several instances where the valuation of the business has been challenged by the Assessing Officer based on the observation that actual financial numbers achieved are in variance with the projections made by the company at the time of raising funds. There are also instances where the valuation is lower in the subsequent round of funding due to various factors such as losses, not meeting the targeted revenues, etc. In these above mentioned instances, the tax authorities have invoked Section 56(2)(viib). Tax authorities are also ignoring DCF method of Valuation and adopting NAV method of valuation to raise tax demands which is not in sync with the option given to taxpayers under the law. There have been a few precedents from the Tax tribunal in favour of the taxpayer but the bulk of the cases have not yet reached higher appellate levels. 

Challenges faced by Start-ups:

1. Since this provision only applies to Indian residents, it is unfair to the start-ups raising funds domestically as against internationally.
2. The threshold limit of Turnover of Rs. 25 crores and Share capital including premium of Rs. 10 crores or less can be easily surpassed disentitling the start-up from the exemption. For start-ups requiring capital in excess of this, the limit may act as a hurdle for raising capital. In such cases, the start-ups may be forced to raise funds exceeding this limit by way of debt which will have a possible interest burden on the business which may not necessarily be profitable enough to absorb such cost.
3. It is difficult to determine the FMV of the start-ups as their cash flows are uncertain and the potential of the business idea cannot be estimated. Also, ‘Fair Market Value’ is a subjective concept and can vary from Investor to Investor and even vary from time to time for the same investor.
4. It is unfair to attack the high Share Premium collected by Private Companies and taxing the difference between the Book Value and the DCF projections as Income. Book value is the present value of the assets while DCF looks at the future earning potential. Investors look at future earnings and not current assets. Most start-ups also have an asset-light business model.
5. The condition to pay 20% of the tax demand to begin the process of appeal is very cumbersome for start-ups, especially because some of the tax notices apply to a significant portion of the capital raised by such start-ups.

Conclusion:

Placing undue onus on start-ups to justify the investors’ source is unfair. As far as the monies are received through banking channels and the start-ups have collected the PAN of all the investors, start-ups must be kept outside the tax net for issuing shares at a premium. This provision has however, affected all the start-ups to the extent that Indian start-ups no longer wish to venture into Indian capital markets. 

Assuming the Government wants to retain the taxing provisions for Start ups, the objective should only be curbing the use of Black money & unaccounted money. Notices should be issued to start-ups only when there is a reasonable doubt on the Share Premium raised. There are other ways for prevention of unaccounted funds coming into start-ups which the Central Government may consider – these are adopted by foreign countries such as Accredited Investor Concept, Bank transfers for all investments, Stringent Anti-Money Laundering and KYC Policies, etc. An Accredited investor is a means of ascertaining sophisticated investors, who can invest in risky asset classes like start-ups, Venture Capital Funds, Hedge Funds, etc. Such investors are self-certified on the basis of their Net Worth, Asset Class or Income Criteria.