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Angel Tax- Issue and way forward
The last two decades have seen a surge in the investment sector, more and more companies, particularly start-up are attracting investments in the form of equity or debt. This positive scenario has also resulted in some companies, either over valuing or under valuing the value of shares for various reasons including avoidance of tax. To counter this avoidance of tax, the Indian tax laws have introduced anti-avoidance provisions in the Income-tax Act, 1961 (“Act”) as Section 56(2)(viia) and Section 56(2)(viib), the former targeting to capture inadequate consideration and the later to capture excess consideration paid in lieu of purchase of shares of a private company.
Section 56(2)(viib) of the Act – Targeting excess consideration received in lieu of shares of the private company:
- Background and Introduction
Section 56(2)(viia) of the Act, (popularly known as the “Angel Tax” provision) is an anti-abuse section with a main objective of curbing the use of the black money in the form of share premium by using of various form of money laundering. Previously, Promoters of closely held companies, by way of double dip transactions or round trip financing used to invest their own money in their own business as share capital.
In addition to that, the companies were used to issue shares at a substantial premium to convert the unaccounted money without providing any valuation for justifying the premium. Although provision for verification of unexplained investments was already in the statue, by virtue of section 68 of the Act, but only if, source of Investments was not being satisfactory, then assessee would be liable. However, by introducing this new provision, the Income Tax Department, is directly charging tax on the amount to the extent of difference of issue price and fair market value of the shares, if such shares issued at the price more than its face value. In other words, it is targeting to directly charge the tax on the excess consideration, rather than going into source of investments, as envisaged under Section 68 of the Act.
- Taxability under Section 56(2)(viib) of the Income Tax Act, 1961:
The said Section, provides that, where a private company issues shares to a resident at a price, which exceeds the face value, then the consideration received is in excess of the fair market value of the shares, will be deemed to be the income of the said private company under the head "income from other sources". Here, it is pertinent to note that, the said section is not applicable in case of consideration received from a non-resident and in case of start-ups subject to approval of the Department of Industrial and Promotion.
- Applicability of notifications issued by the Department of Industrial and Promotion:
The Department of Industrial and Promotion (“DIPP”), vide various notifications, to encourage the start-up ecosystem in India, has made the above provision inapplicable to Start-ups. The DIPP has clearly laid down parameters for an entity to qualify as a Start‑up and the parameters under which the investor can seek an exemption from the applicability of Section 56(2)(viib) of the Act, which is as provided below:
(1)The aggregate amount of paid-up share capital and share premium of the start-up after the proposed issue of shares does not exceed 10 crore rupees,
(2) The investor/proposed investor, who proposed to subscribe to the issue of shares of the start-up has,
(a) The average returned income of Rs.25 lakh or more for the preceding 3 financial years; or
(b) The net worth of Rs. 2 crore or more as on the last date of the preceding financial year,
(3) The start-up has obtained a report from a merchant banker specifying the fair market value of shares in accordance with Rule 11UA of the Income-tax Rules, 1962.
However, in case the company is not eligible for registration under DIPP as a start‑up, the said company cannot take shelter under the notification issued by DIPP. In such a case the value of shares has to be determined based on the fair market value.
- Methods prescribed under the law for the computation of fair market value of shares:
The computation mechanism of Fair Market Value (“FMV”) of the shares is discussed below:
For the purpose of taxability under section 56(2)(viib), the Fair Market Value means higher of the following:
- the value arrived at on the basis of the method prescribed under Rule 11UA Income Tax Rules, 1962 (“the Rules”) , or
- the value as substantiated by the company to the satisfaction of the Assessing Officer (“AO”). The company can substantiate the value based on the value of the tangible and intangible assets and various types of commercial rights as stated in the clause.
In other words, under clause (a), the company has an option to either follow Net Asset Value (“NAV”) method or Discounted Cash Flow (“DCF”) Method as per Rule 11UA of the Income-tax Rules. Alternatively, under clause (b) above, the company also has an option to follow a different valuation method other than NAV and DCF, however, in such a scenario the same has to be substantiated by the company before the AO, as the AO has the powers to ask for the substantiation of such method.
Further, practically, in my experience, while the DCF method is prescribed under the Income-tax Rules and is certified by a merchant banker, the method of valuation for the same is not provided in detail as provided for NAV method. The entire DCF valuation method is based on the projections and assumption which are subjective in nature and open to manipulations, and due to this vulnerability of the method, the AO, more often than not, questions the legitimacy of the valuation carried out under the DCF method.
If shares value is as per DCF method, then it has to be determined by a Category –I, Merchant Banker registered with Securities and Exchange Board of India and not a Chartered Accountant Valuation.
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