A performer rolls around on stage in a giant hoop during the closing ceremony of the 2006 Winter Olympic Games. (Photographer: Adam Berry/Bloomberg News)

Inability to Carry Forward Losses Will Hurt Startups

Over the last few years, section 56 of the income tax law has almost become synonymous with angel tax. Issuance of shares to an Indian resident at a price in excess of the fair market value of the shares attracts this provision. And the tax department has used it to the hilt to go after startups and question the value at which shares are issued by them to their investors. This approach drew sharp criticism from tax practitioners and judiciary at the recent conference of International Fiscal Association.

The angel tax provision doesn’t serve any purpose at all because you’re taxing the capital receipt as income which is a no-no in taxation, Justice Badar Durrez Ahmed, former Chief Justice of Jammu & Kashmir High Court, said.

You can’t have any method of valuation at all because that’s a judgment call that a man makes when he puts his money into a business. In which case, Section 68 by itself must be sufficient.
Justice Badar Durrez Ahmed, Former Chief Justice, Jammu & Kashmir High Court

Section 68 deals with unexplained credits and is used by the department to question the source of funds, identity and credit-worthiness of investors, genuineness of the transaction etc. The tax department’s worry should only be genuineness of the funds and it shouldn’t get into what should be the appropriate value at which shares should’ve been issued, Rohan Shah, an advocate at Bombay High Court, said.

The Section 79 Issue

The angel tax issue has been addressed to a certain degree by the Department for Promotion of Industry and Internal Trade and the tax department. To a certain degree since the tax department’s position of now not applying section 56(2)(viib) will not be applicable to cases where tax demand has been raised or scrutiny assessment notices have been issued.

As startups continue to battle the angel tax issue, another provision may soon pose a significant challenge to them—section 79 which was amended through Finance Act, 2017. This section denies startups the benefit to carry forward and set-off losses if there is a change in their shareholding. This benefit is available to startups only if the shareholding in the year loss was incurred and in which loss is to be set off remains the same, Parul Jain, partner at Deloitte India, explained.

The startup can only carry forward the losses if all of the shareholders—who were shareholders in the year losses were incurred—are the ones when the startup wants to utilise the loss. The requirement to have all the shareholders as is doesn’t work.
Parul Jain, Partner, Deloiite India

For a startup, let’s say one private equity investor goes and another one comes in—it might result in losing this benefit, Ajay Vohra, senior advocate at the Delhi High Court, said.

Any further capital that a startup raises may result in foregoing the benefit of carry forward and set-off of losses. And when this startup makes a profit, it won’t be able to carry-forward and set off losses if the shareholding has changed.
Ajay Vohra, Senior Advocate, Delhi High Court

For companies other than startups, the benefit is available as long as 51 percent of shareholders continue to be the same and this should be made applicable for startups as well, Vohra said.

Without elaborating further, Anil Agrawal, joint secretary, DPIIT, said at International Fiscal Association conference that his department is considering this issue.

Watch the IFA panel discuss the tax disputes in the startup world here