What is Angel Tax?
The controversial Angel Tax is governed under 56(2) (viib) of the Income-tax Act, 1961. This tax was introduced as an anti-abuse provision in the 2012 budget to curb practice of laundering unaccounted income masquerading as investment in the share capital of a company.
Under this section, if a closely held company issues shares to resident investors at a price exceeding its Fair Market Value (FMV) arrived at as per Rule 11UA of the Income-tax Rules, 1962 then the consideration as exceeds FMV is taxable as Income from Other Sources in the hands of the recipient company, and taxed at around 25%.
Issues due to Angel Tax
- Though the law offers a choice of valuation methodologies to a startup company, assessing officers often disregard this freedom and instead taking it upon themselves to value the startup like an investor would, but without actually investing the risk capital behind this themselves.
- In some cases, tax authorities ignore valuation reports certified by merchant bankers or chartered accountants in favor of the net worth of the company. Valuation of start-ups based on their net assets alone is not appropriate since valuation is a forward-looking number which captures future potential value of the startup, and intangibles such as IP, goodwill, etc are not necessarily reflected in their balance sheets.
- The concept of taxing capital receipts and investments as income does not exist in most countries other than in India. Conflicting guidelines and circulars by the CBDT issued ever so often do not help.
- Assessing officers often demand bank statements, income tax returns and financial statements of the investors from startups. Given the sensitive nature of these documents, many investors may not be comfortable sharing them with their investee companies.
- Startups do not maintain adequate data/backup to support valuations. Issuing shares at different prices to difference investors at the same time; high escalation in valuations within a very short span of time; not maintaining mandatory data required under law also add to the weak position of startups in defending tax claims during assessments.
Tips to avoid complications
- Ensure financial projections made for valuation reports are well thought through and reflect the business model as closely as possible. Work with your valuer to convincingly support the valuation numbers by ensuring that all business risks, liabilities and assumptions are clearly documented in the valuation report.
- Get registered for exemption under Section 56 under the Startup India scheme to CBDT via DIPP by submitting an application in Form-2 with DIPP. To qualify, the venture must fulfill criteria on age (not more than five years old and incorporated after 1 April 2016), share capital & share premium (not exceeding INR 10 Crores), purpose (building innovative product or services), and method (unique technology or registered intellectual property). Minimum income (Rs 50 lakhs in preceding financial year) and net worth (INR 2 Crores or invested amount, whichever is higher) criteria for angel investors should also be met.
- Check with your investors if they can invest through funds registered with SEBI. Section 56(2) (viib) specifically excludes investments made by SEBI registered funds from its ambit. Also, this section is applicable only in the case of resident investors; non-resident angel investors are excluded.
- Involve tax advisors along with legal advisors in on the investment transactions early on. Understand tax implications – especially if the startup is raising multiple rounds of funding at different valuations very close to each other. High valuations are more frequent in countries such as US, Singapore, etc. Startups may consider raising investments in their group companies outside India – economic feasibility and proper structuring is advisable in this case.
- Collect data required under law (PAN, basic KYC documents) of investors, and of course, do not accept investments in cash.
- Maintain a trail of communication with investors at the time of negotiating the investment deal and valuation, about the progress of company, justifications / reasons for deviation between projections and actuals, etc. This will help in defending valuation during the course of income tax aassessment.
Article Contributed by:
Narayan Bung, Manager Projects
CA Sujata Bogawat, Senior Partner
Baheti & Somani, Chartered Accountants
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