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Angel Investment Tax Has Startups And Their Investors Worried

Tax notices threatens Modi government’s attempt to create a conducive environment for startups.



Photographer: Udit Kulshrestha/Bloomberg
Photographer: Udit Kulshrestha/Bloomberg

In February last year, the government kicked off its Startup India initiative ‘for creating a conducive environment for startups in India.’ But a flurry of recent tax notices to startups and their investors tell a different story.

The Contentious Section

The notices to startups have been sent under Section 56(2)(viib) of the Income Tax Act, 1961. Titled income from other sources, the Section says that any excess consideration received by a company will be treated as its income if it issues shares to a resident at a price which exceeds the fair market value of the shares. The Section does not apply if consideration is received from venture capital companies, venture capital funds or a class of persons notified by the government.

The government didn’t clarify the intent of this Section when it was amended by the Finance Act, 2012, pointed out Maulik Doshi, a partner at tax and consultancy firm SKP Business Consulting in an email interview.

The intent, however, seems to be that the government wanted to discourage the practice of corporates issuing shares at a high premium which are not backed by underlying value of the shares. There were also instances where corporates were getting into tax planning by keeping low capital base and high premium so that dividends and consequent dividend distribution tax are kept to minimum.
Maulik Doshi, Partner, SKP Business Consulting

Giving With One Hand…

In June last year, the government notified the ‘class of persons’ who will be exempt from Section 56(2)(viib) applicability - any resident who invests in a startup at a value which is more than the face value of its shares. But not all such investments were granted immunity. Only those startups that fulfill the criteria laid down by the government as part of the Startup India initiative in February 2016 would qualify for this exemption. The criteria range from demonstrating innovation to creation of value for customers.

….Taking Away With The Other

Many of those incorporated before February 2016 are now staring at tax notices that require them to pay tax on income on account of share premium.

The tax department’s argument is this: For instance, the face value of shares of a startup is Rs 10. Assume that in its first round, the startup, based on a certain valuation, issues shares at Rs 100 per share and in the following round at Rs 80 per share due to a downward revision in its valuation. The difference of Rs 20 between the last and the previous round, as per the tax department, is an excess consideration, and should be treated as income in the hands of the company and taxed at 30 percent.

Even if a company has issued shares at a very high premium as compared to the face value, as long that the high premium can be justified by way of a proper valuation mechanism, there should not be any tax implications, Doshi said.

The tax authorities by and large have followed this legal position. The way they are now approaching is that they question the valuation mechanism and numbers used for valuation. They are questioning the valuation of the initial funding without appreciating the business realities and the fact that the valuation numbers have declined due to economic circumstances.
Maulik Doshi, Partner, SKP Business Consulting

The companies who have got these notices are early stage companies and it’s very difficult to value them, Pravin Gandhi, managing partner at angel investment firm Seedfund told BloombergQuint.

It appears that there is no scientific method that the department is using to contest the valuations. In one of our portfolio companies, a demand for Rs 12 crores was raised and during the discussion, we contested the order and refused to pay. At that time, we were told if we don’t pay X amount, the company’s accounts will be frozen.
Pravin Gandhi, Managing Partner, Seedfund

Saurabh Srivastava, founding member of Indian Angel Network added that most technology startups will fall foul of Section 56(2)(viib). “There is no concept of fair market values for such companies. It is the value at which the entrepreneur and the investor agree to invest. There is no way anyone else can determine it. Five angel investors will value the same company differently. It’s a judgment call,” Srivastava explained in a telephone interview.

He added that since this section only applies to receipt of excess share premium from Indian residents, it is discriminatory against startups raising funds domestically as against internationally.

Angel Investors’ Angle

The notices haven’t reached just the startups but their investors too. These are under Section 68 of the Act that makes unexplained income liable to tax if the department is not satisfied with explanations regarding the source of funds.

Even after explaining the genuineness of investments, the tax department is concluding that the transactions are bogus or unexplained, and treating the entire investment amount as income on the basis of Section 68, Gandhi said.

Representations made by angel investors to the Indian Private Equity and Venture Capital Association point out that the conclusion drawn by that tax department is on the following grounds:

  • One, since investment is made through Mauritius route, they are assuming it is to avoid tax in India and avail of treaty benefits.
  • Two, they are questioning as to why investments are made in loss-making companies at a premium.
  • And three, they are also alleging that via such transactions, black money from India finds its way back into the market through Mauritius.
What is relevant at the time when investments are received in the form of share capital is the source of funds of such investment, the identity of the investor and his ability to invest the funds. These requirements are discharged by filing for the certificate of incorporation of the fund, registration certificate from Financial Service Commission of Mauritius, the tax residency certificate of the fund, Permanent Account Number issued by tax authorities in India to the fund, list of shareholders and financial statement of the fund.
Pravin Gandhi, Managing Partner, Seedfund

The profits arise only on the sale of investment and not at the stage of investment itself, Gandhi said. Whether such profits are liable to tax or not is not relevant at the time of investment. Therefore, investments from Mauritius can be questioned, if at all, only when capital gains are actually realized on the sale of investment, he added.

Are All Startups Holier-Than-Thou?

A March 2016 tax department notice, reviewed by BloombergQuint, shows the company submitted two valuation reports to the department; admitting an arithmetic mistake in the first one. But both the reports submitted a valuation for 50,000 shares when the actual number of shares allotted by the company were 65,666. Also, the department noted that in the same year, shares were sold at face value and then at a premium.

Doshi points out that there are cases where the share issue price and premiums are not backed by robust valuations. If the valuation report is not robust with proper and logical workings, the tax authorities are within their right to question such valuations and levy tax on the higher premium received by the company as per the provisions of law, he added.

Such notices, experts quoted in this story say, are exceptions; not the rule. They claim that the zealousness with which the notices are being issued will make the Startup India initiative a non-starter.