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In angel tax assessment, shift focus from companies to investors
S. Vasudevan, partner, and V Sriram, principal associate, Lakshmikumaran & Sridharan Attorneys

While the jury is still out on whether the 16 January notification of the Department of Industrial Policy and Promotion (DIPP) has slayed the devil in the angel tax, it is clear that the central government is keen to take steps to settle this issue. This issue started with the introduction of Section 56(2)(viib) in the Income Tax Act, popularly known as angel tax, in the Union Budget of 2012-13, as a measure to prevent generation and circulation of unaccounted money.

There is no precise statistic available to gauge the effectiveness of this provision in preventing the generation and circulation of unaccounted money. However, the consequences have been that genuine startups have been subjected to unnecessary troubles because of valuation, which is essentially a dynamic and fuzzy item.

Startups have received notices from the taxman asking them to justify their valuations and demanding tax at 30% on the portion of angel investments received in excess of the fair market value of the startup.

Bottling something that cannot be bottled

One aspect that every founder, promoter, investor or an investment banker will readily agree on is that there is no “correct” valuation. Valuation is like a spirit that cannot be bottled. Valuation is very dynamic and there is no “correct” value. A question then arises -- whether this provision is barking up the wrong tree by going after startups and companies raising funds and by trying to determine the “correct” valuation (the fair market value to be more precise) for those companies instead of chasing the person holding the unaccounted money?

Angel tax provision explained

According to Section 56(2)(viib) in the Income Tax Act, if a closely held company (that is, unlisted company) issues shares at a premium and the issue price exceeds the fair market value of shares, then the difference between the aggregate issue price of shares and the fair market value of shares is taxable under the head ‘other sources’ in the hands of the closely held company. As an illustration, say, company Y issues 1,000 shares at Rs 50 apiece (including share premium of Rs 40) when the fair market value of the shares is Rs 30. The portion of the aggregate funds raised exceeding the fair market value, therefore, is Rs 50 minus Rs 30, that is, Rs 20 per share multiplied with 1,000 shares, resulting in Rs 20,000; the latter amount is subject to tax in the hands of company Y as income from ‘other sources’.

Section 56(2)(viib) in the Income Tax Act provides choice of methods for determining fair market value of the closely held company’s shares – the net asset value (NAV) method or the discounted cash flow (DCF) method. The choice of method lies with the closely held company (the assessee). If the DCF method is adopted, the valuation has to be certified by a SEBI-registered merchant banker or a chartered accountant. SEBI is Securities and Exchange Board of India.

Guilt for someone else’s fault!

Along with the insertion of section 56(2)(viib) in the Income Tax Act, the Union Budget of 2012-13 also introduced a condition in Section 68, deeming the funds received by the closely held company to be unexplained funds unless the angel investor provides an explanation to the assessing officer and the latter finds the explanation satisfactory. This vested the assessing officer with the power to deem the funds received by the company to be unexplained funds on account of shortcomings of an investor even if the assessee explained the nature and source of such funds.

So how is the angel tax provision affecting startups?

It is very well-known that startups have gone through multiple rounds of fundraise in the last five to six years, with several startups witnessing more than one round of fundraise within a financial year. It is also well-known that several startups have gone through succeeding rounds at lower valuation than previous rounds, that is, down rounds.

With so much variation in valuation, it has been nothing but a conundrum for the taxman. This has compelled the taxman to either question the choice of valuation methodology (and its assumptions) despite the methodology being at the assessee’s discretion or to insist on using the NAV method. No startup would like to value itself by looking at the past…when everything is about the future.

Remedy offered by the government

Taking note of the representations from the industry, in June 2016 the central government notified that it would exempt startups fulfilling conditions in the DIPP notification of February 2016 from the angel tax provisions.

Starting with the February 2016 notification, the government came out with a series of notifications and amendments in May 2017, February 2018, April 2018 and December 2018 – all of them either trying to define a class of startups or coming up with parameters to identify startups that can be exempted (a sort of certified or accredited startups) from angel tax provisions or instructing assessing officers not to take coercive action against startups for recovering tax.

January 2019 notification

This latest notification from the DIPP tries to ease some of the pain points identified by startups in the process notified in the April 2018 DIPP notification based on representation from industry bodies. This notification, for one, eliminates the need for merchant banker valuation certificate for approval process; two, permits startups that have already issued shares to also apply for approval; and, three, provides for a period of 45 days from application to DIPP for receiving approvals.

However, an important downside of this notification is that it leaves out startups in respect of which the assessment order has already been passed.

What to expect?

This notification is a definite indication that the central government is keen to resolve issues faced by startups in line with ease of doing business. Moreover, for startups that were not able to avail the benefit of the exemption, the albatross still hangs around their necks. It is hard to say what the future holds for the startups. Perhaps it is time to break from incrementalism and shift the focus from the companies receiving funds to persons holding unexplained funds – a la accredited investors. Since this issue affects not only startups but also well-established companies, such a change coming in the run-up to the general elections is not likely to go unnoticed by those yearning for reforms.

S Vasudevan is partner and V Sriram is principal associate at Lakshmikumaran & Sridharan Attorneys. Views are their own.

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