Angel Tax exemption helps, but tight reins hinder start-ups’ growth

Hiten Kotak/Aditya Narwekar | Updated on November 14, 2019

The Angel Tax exemption will be revoked with if start-ups fail to meet the conditions   -  istock

The current conditions that start-ups seeking Angel Tax exemption must meet restrict their investment opportunities. Easing of these rules will boost the start-up ecosystem and result in more unicorns

India has grappled with the problem of money laundering and parallel economy since time immemorial. There have been different measures adopted to curb such practices over the years. A new provision, Section 56(2)(viib) of the Income Tax Act,was introduced in 2012 Union Budget. The provision was sought to tax untenable share premium over and above the fair market value (FMV), which was widely used as a means for circulating unaccounted money.

This provision, popularly referred to as ‘Angel Tax’, prescribes a valuation methodology for determining the FMV of shares issued. The FMV is higher for the value determined as per the formula under the income tax rules (primarily based on book values) or Discounted Cash Flow method, at the option of the taxpayer; or any such value substantiated by the taxpayer to the satisfaction of the assessing officer.

This provision is applicable only to shares issued by closely-held companies to resident Indians. However, a certain category of investors — including venture capital funds and specific funds — are exempt from the applicability of this provision.

Start-up exemption

Generally, companies issue shares at a premium with a view to fortify their capital base, and such premium is based on the commercial negotiations between the investors and the companies. Typically, the investors agree to a premium (especially in case of start-ups) in anticipation of the unique products/ideas materialising into an established business in the future.

Many start-ups received notices from the tax authorities questioning the valuation methodology used for determining the FMV of shares. Consequently, the issue that arose was whether the authorities had the right to do so. Contrary views were adopted on this subject by different judicial and quasi-judicial authorities.

While the rulings are fact-specific, the key principle emanating was that the assessing officer could not disregard the valuation methodology adopted by taxpayer. However, the officer has the right to examine the underlying assumptions made for the purpose of the valuation of shares. As the start-up valuations are based on future cash flows, which are not generally backed by historical data, it becomes difficult to justify the assumptions with substantive documentation.

Based on representations made by the stakeholders, an exemption was provided to the start-ups to encourage investment in and growth of start-ups, provided they satisfy certain conditions:

The start-up must obtain a certificate of recognition from the DPIIT/DIPP.

The aggregate amount of post issue (including proposed issue) paid-up share capital and premium should not exceed ₹25 crore. This does not include investments by non-residents/venture capital companies or venture capital funds.

Additionally, such start-ups shall not be allowed to invest in certain specified assets for a particular duration, viz seven years from the end of the financial year in which the shares are issued at premium. Some of these assets include land, buildings, shares and securities, etc.

The exemption shall be revoked with retrospective effect if the conditions are breached.

The Central Board of Direct Taxes (CBDT) recently clarified this exemption. The CBDT also laid down rules for assessment of start-ups under these provisions to ensure that notices are sent after adequate due diligence has been undertaken.

The conditions laid down for availing the exemption are quite onerous and restrictive. For instance, a blanket restriction on investment in shares and securities impairs the ability of a start-up to expand its operations through acquisitions or setting up of subsidiaries. Therefore, though the exemption is a move in the right direction, the related conditions may have made it ineffective.

Impact on non-residents

The provisions of Section 56(2)(viib) are applicable only to investments made by residents. Moreover, the authorities sought to tax non-resident investors under Section 68 of the I-T Act, questioning the source of funds. This provision lays down the method of establishing the bona fide details of an investor to ensure that such investments do not become a conduit for money laundering.

This section does not provide any exemptions currently. One will need to wait and watch if similar carve outs are provided here.

The current government has been largely investment-friendly and has been taking various measures to remove any obstacles faced by the industries and other stakeholders in their day-to-day operations. The recent changes to the foreign direct investment policy for single-brand retail augments this resolve.

While the exemption to start-ups from Angel Tax is a positive step towards ease of doing business, relaxations on the thresholds and other conditions would bring in further simplicity for investments. It would lay the path towards a more start-up-friendly ecosystem and pave the way for more unicorns in the near future.

Kotak is Partner and Leader and Narwekar is Partner, M&A Tax, PwC India. Views are personal

With inputs from Jaisri S and Vidushi Agarawal, M&A Tax Team, PwC India

Published on November 14, 2019

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