A person uses uses a magnifying glass to browse a document. (Photographer: Matthew Lloyd/Bloomberg)  

Startups In Uproar Over Angel Tax: The Tax Department’s Point Of View

Tax notices. Uproar. Ministry intervention. Calm. Repeat. That in five words is what’s been playing out in the startup world for the last couple of years. Startups receiving tax demand notices has almost become an annual exercise now. Several founders have taken to social media over the last few days to express their anguish over what’s come to be known as Angel Tax.

But some of these notices are not entirely without merit and unless the tax department makes inquiries via such notices, there’s no way of determining genuine startups from the scrupulous ones, PK Prasad, former income tax commissioner in Bengaluru, said. A tax officer never starts by giving the benefit of doubt to an assessee and so to argue that no inquiry notices should be sent just because some angel investors are well-known names, has very little meaning for the department, a Karnataka-based joint commissioner in the income tax department told BloombergQuint on the condition of anonymity.

What Are The Notices About?

The notices fall under two buckets:

First, fresh notices under section 56(2)(viib) of the Income Tax Act. 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.

Let’s say, the face value of shares issued by a startup is Rs 10. Assume that in its first round, the startup, based on a certain business valuation, issues shares at Rs 100 a piece and in the following round at Rs 80 due to a downward revision in its valuation. The tax department’s view seems to be that the 20 rupee difference between the last and the previous round is an excess consideration, and should be treated as income in the hands of the company and taxed at 30 percent.

To be clear, not all cases involve downward revision of valuation. Several startups have received notices pertaining to their first round of angel investment, where the tax department has disregarded their Discounted Cash Flow (DCF) valuation.

The second bucket of notices have been issued under section 142(1). A notice under this section is sent by an assessing officer to ask for additional documents required to carry out a scrutiny assessment.

The assessing officer has to complete an assessment within 21 months of the end of the assessment year or 33 months of the end of the financial year, Amit Maheshwari, a partner at Ashok Maheshwary & Associates explained.

Notices issued for assessment year 2016-17 will become time barred by December 2018, which could’ve prompted the department to send notices for additional information.
Amit Maheshwari, Partner, Ashok Maheshwary & Associates

The additional information asked for typically includes details of trade payables, sundry creditors, ledgers of all creditors, their income tax details, proof of their creditworthiness and genuineness etc. A copy of a notice issued under section 142(1) has been reviewed by BloombergQuint.

Also read: Angel Tax: Will The Wicked Consume The Righteous?

The Revenue Point Of View

Section 56 is an anti-abuse, anti-avoidance provision. There are several businesses which are not genuine and they tend to evade taxes in the garb of startups, Prasad said. He pointed out that the department gets information on entities from the Department of Industrial Policy & Promotion (Commerce Ministry) and those certified/registered ‘startups’ are not sent notices. For the remaining, it is important for the department to investigate which startups are genuine and which are not, he added.

After a notice is issued and a reply is received, is when the tax department can determine who is genuine and who’s not. If they’re satisfied, the matter will end there. But you can’t do away with the legal procedure and say notices of inquiry itself shouldn’t be sent out.  
PK Prasad, Former Income Tax commissioner, Bangalore

Tax is part of the business activity and you cannot wish it away, Prasad said. But it is also incumbent on the tax department to see that there are no leakages and the provision isn’t used for harassment, he added.

If a business doesn’t fall within the DIPP definition of a ‘startup’, the nuances of section 56(2)(viib) will apply to them, the other Karnataka-based joint commissioner said. In April this year, the DIPP had issued a circular to define a startup - an entity who works towards innovation, whose revenue has never exceeded Rs 25 crores since incorporation, has received angel funding of up to Rs 10 crore etc, will be exempt from the applicability of section 56(2)(viib)

The joint commissioner said there have been instances where kickbacks to politicians, bribery had taken place using the startup route, which is why section 56 was introduced. But once that section is there in the statute, the application is not limited to only these instances, the officer said.

On applying this provision, the department has discovered several cases where companies were set-up just to accept cash. He used an illustration to explain his point- let’s say there’s a person ‘X’ who works at a listed company and has inside information about it. He shares that with a broker who agrees to give him a commission, of say Rs 50 crores, from this share trade. Now ‘X’ doesn’t want to pay tax on this amount and so will set up a company and ask the broker, or his associate, to invest in his company at a very high valuation. The department has discovered such cases, the joint commissioner asserted, and in some there was even a genuine business model, but the source of funding was unscrupulous. Should the department not even send notices to uncover such cases, he asked.

When questioned why the department disbelieves valuations submitted by startups, the officer stated it’s difficult to value an idea. The DCF method which is broadly used by startups, he said, has three variables- cash flow, discounting factor and terminal growth rate. Even a slight tweak in these variables, he added, could change the value of the company substantially. If an assessing officer accepts the valuation submitted by the business, without applying his mind, there could potentially be a vigilance inquiry against him.

And finally, on the question as to why notices are being sent to startups with well-known angel investors, this officer said that for the income tax department, reputation doesn’t matter. The assessing officer will never start by giving the benefit of doubt to the taxpayer and only after a thorough investigation, an officer can conclude that no adverse inference can be drawn.

Government’s Response

Taking note of the uproar over Angel Tax, the DIPP this week said in a media note that in consultation with the tax department, it has put in place a mechanism since April 2018 to grant exemption from section 56(2) (viib) to genuine investors in recognised startups.

But businesses say, the DIPP statement doesn’t mean much. Sreejith Moolayil, co-founder of the health food startup True Elements said that he’s got two notices so far inspite of being registered with the DIPP.

The first notice was in December 2017 for the angel funding we raised in January 2015. We raised another round in April 2015 and though a demand on it hasn’t been raised as yet, we’ve been asked for explanation of the share premium amount. 
Sreejith Moolayil, Co-founder, True Elements 

While one would have assumed that the intention of the government was to not harass genuine startups, the latest push from overzealous authorities seems to suggest inadequate understanding of the ecosystem and funding requirements at the ground level, tax expert Maheshwari pointed out. The government should revisit the valuation methodology to remove subjectivity in valuation norms and avoid this unnecessary litigation, he added.

Late Thursday evening, the tax department issued a statement that it will set up a panel of experts from Indian Institutes of Technology and Indian Institutes of Management to examine the Angel Tax problem.