The last couple of months have been quite interesting in the startup ecosystem in India, given the legislative changes in the context of Section 56(2)(viib) of the Income Tax Act, 1961, or what we know as the ‘Angel Tax’ provision. This post is an attempt to analyse the legislative context and critically evaluate the current situation.
Introduction of Angel Tax
The legislative context of Angel Tax, introduced through the Finance Act 2012, is rather fascinating. The then Minister of Finance Mr. Pranab Mukherjee introduced his Budget Speech of 2012 – 2013, on a reformative note mentioning the various challenges of a global recession that the Indian economy was striving not to get affected by at the concerned point of time in reference. The tone was very clear on how the Indian economy was then at a juncture to take hard decisions. One of the five objectives that the Union Ministry sought to address was “… the problem of black money and corruption in public life”. A series of measures were therefore proposed “to deter the generation and use of unaccounted money”, including “increasing the onus of proof on closely held companies for funds received from shareholders as well as taxing share premium in excess of fair market value”, taxable at the highest rate, irrespective of the slab of income.
There are some views that this proposal was also made in the aftermath of certain money laundering investigations launched about the same time, where bribe money was allegedly laundered by routing it through various individuals and companies and getting investments at a high premium.
Interestingly, investments in a private limited company at that point of time was being governed primarily under the Companies Act, 1956, which lacked the severity and rigour brought in by the private placement mechanism and preferential allotment modes, under the Companies Act, 2013, in a bid to provide better protection to stakeholders by enforcing accountability and transparency.
Industry Woes and Consequences
- The language of Section 56(2)(viib), as introduced by the Finance Act 2012, provides for taxation of consideration received by private limited companies for issue of shares, in excess of fair market value (FMV) of the shares. Exemption under the same is available if such consideration is received from ‘venture capital undertaking’ or ‘venture capital company’ or ‘venture capital fund’ and any other ‘class of persons’ as may be notified by the Central Government in this behalf.
- FMV would be as determined in accordance with Rules 11U and 11UA of the Income Tax Rules, 1962 or as may be substantiated by the company to the satisfaction of the Assessing Officer based on value of assets (including intangible assets, goodwill, intellectual property, business or commercial rights, etc.), whichever is higher.
- Rule 11UA provided for the computation of valuation of unquoted equity shares under Section 56(2)(viib), either as per a mathematical formula, or as determined by a merchant banker or an accountant as per the Discounted Free Cash Flow (DCF) method, at the option of the assessee.
As a consequence, early stage companies started moving ahead with chartered accountant determined valuations for investments raised from resident angel investors, following the DCF method. This was also in parity with the requirement for the private placement process under Rule 13 of the Companies (Share Capital and Debenture) Rules, 2014. However, the risk still remained to the extent the same could not be substantiated to the satisfaction of the Assessing Officers, upon receipt of a notice in this regard.
Assessment to the satisfaction of the Assessing Officer, on a literal interpretation, may be considered as taking a step towards understanding the business perspective while putting in place right checks and balances for curbing money laundering and corruption. However, any element of satisfaction, has its own nuances and brings in a certain amount of discretion that is required to be exercised with caution, especially in the context of varied business ideas and models that could be novel in the Indian context and therefore would require a greater understanding and knowledge of the intellectual property or goodwill or business or commercial rights thereof. The understanding would also have to be basis different commercial contexts, such as the implementation of anti-dilution rights. Such rights are typically available to financial investors and often entail issuance of additional shares at minimum price, to give effect to commercially agreed upon rights.
Much has been written on the multiple incidents of startups receiving notices under Section 56(2)(viib), having to justify commercially driven business decisions. This has led to various representations to the Government by industry bodies, to take a re-look and if possible bring down Section 56(2)(viib).
The Plethora of Subsequent Legislative Changes
The first sign of relief came with the introduction of the Startup India Action Plan launched by Prime Minister Narendra Modi on 16 January 2016 (the “Action Plan”), as part of a flagship initiative of the Government of India for boosting the startup ecosystem in India.
- The Action Plan brought forth a definition of ‘Startup’ and conditionalities based on which a Startup could be considered for recognition under the Action Plan. The Action Plan also recognised that it is difficult to determine FMV of shares in the context of Startups, which might very well be just at conceptualization or development stage and in most cases capital investments in Startups would be made at much higher valuations than what could be traditionally considered as FMV, which is the exact scenario that falls under the ambit of Section 56(2)(viib).
- With this background, the Action Plan extended the exemption under Section 56(2)(viib) to investments made by incubators in Startups as well.
- What followed a few months later is a notification dated 14 June 2016, issued by the Central Board of Direct Taxes (CBDT) that further extended the exemption, in the context of recognised Startups to ‘person’ as defined under Section 2(31) of the Income Tax Act, 1961. This includes individual, hindu undivided family, company, firm, association of persons, local authority, and any other artificial juridical person.
This led many early stage companies to strive for recognition under the Action Plan. Unrecognised startups/early stage companies, however, continued to struggle with the woes of the Angel Tax regime.
Amidst all of this, the Department of Industrial Policy and Promotion (DIPP) has now issued a notification dated 11 April 2018 that introduces the following additional nuances for recognised ‘Startups’ also:-
- Any ‘Startup’ falling under the ambit of the definition provided as such in the notification and being a private limited company, can now be considered for an ‘approval’ for the purposes of Section 56(2)(viib), if certain conditionalities are fulfilled.
- The conditionalities include – (a) the aggregate amount of paid up share capital and share premium after the proposed issue, not exceeding Rs. 10 Crores;
‘Proposed’ could be read as ‘prior approval’, meaning a recognised ‘Startup’ would now have to wait for an approval before they can raise seed level funds from resident angel investors, which are many a times, crucial for jet-setting the business. Speedy execution and implementation being the foremost criteria for raising such seed level funds by early stage companies, introducing an element of ‘prior approval’ could be massively counter-productive.
Further, the process appears to be each investment based and not a one time approval.
(b) The investor/proposed investor has to have an average returned income of at least Rs. 25 Lakhs for the 3 preceding financial years or the net worth of at least Rs. 2 Crores on the last date of the preceding financial year;
Although this might be akin to the general theme of deterring the generation and use of unaccounted money, the question that one might have is whether the intent is to then tax and therefore, restrict angels, friends and family driven or similar early stage investments, below the given threshold.
Quite interestingly, the form in which a Startup has to apply for the approval not only includes disclosure of such details of the investor, as mentioned above, but it also requires the name, PAN and address of the existing shareholders (without any qualification as to resident or non-resident) along with the price point at which they had invested.
(c) the Startup also has to obtain a report from a merchant banker specifying the FMV in accordance with Rule 11UA.
Early stage investments raised from resident angels, most often, are not very significant amounts and mainly utilised for helping businesses get a footing till such time that they reach validation stages and therefore seek larger amounts as venture capital funding or other forms of institutional funding. Introducing a ‘merchant banker valuation’ justification for such investments, would not only mean increase in cost to companies but also be a deterrent to raising small funds.
Within a couple of months from the above-mentioned DIPP notification, the CBDT issued 2 notifications dated 24 May 2018, one omitting the word ‘or an accountant’ from Rule 11UA, and the other extending the exemption under Section 56(2)(viib) to consideration received in accordance with the approval granted by the Board under the DPP notification.
With all of the above changes, the current position with respect to valuations and Section 56(2(viib) stand as follows:-
- Receiving Investments from Resident Investors by Recognised Startups – Approval mechanism, requiring merchant banker valuation, unless investment is being received from exempted categories.
- Receiving Investments from Resident Investors by Unrecognised startups/private limited companies – No approval mechanism However, merchant banker valuation would still be required, unless investment is being received from exempted categories.
- Receiving Investments from Non-Resident Investors by Unrecognised startups/private limited companies – Section 56(2)(viib) is not applicable and therefore companies could still make do with a chartered accountant valuation report that works well both under the Foreign Exchange Management related regulations and under the Companies Act, 2013.
In our view, the situation detailed above needs a closer evaluation by the Government, so that while curbing corruption and money laundering, business is also facilitated. The general theme in the country currently being ensuring ease of doing business, a more balanced approach is required with respect to taxation also. More importantly, direct taxation being a concept linked with direct gains, the question that really needs to be evaluated here is whether at all early stage “investments” can be construed as direct gains.
Author: Sohini Mandal, Associate Partner
 Budget 2012-2013, Speech of Pranab Mukherjee, Minister of Finance, March 16, 2012, as available at https://www.finmin.nic.in/sites/default/files/bs1.pdf?download=1 (visited on June 12, 2018)
 Nakul Saxena and Siddharth Pai, Policy Expert Council Members, iSpirt Foundation, The History and Future of Angel Tax, February 12, 2018, as available at http://pn.ispirt.in/the-history-and-future-of-angel-tax/ (visited on June 11, 2018)
 The DIPP notification dated 11 April 2018 also provides for approvals to be provided by an Inter Ministerial Board of Certification (the “Board”), to be formed with 8 members from the DIPP, Ministry of Corporate Affairs, Reserve Bank of India, Securities and Exchange Board of India, CBDT, etc.