Angel tax was introduced in the 2012 Budget by the then finance minister Pranab Mukherjee to deter the generation and use of unaccounted money.
By Vinti Agarwal
The last couple of months, the media has been agog with stories of notices received by many start-ups as well as angel investors on clearing the taxes on the angel-funding raised by the former. Angel tax was introduced in the 2012 Budget by the then finance minister Pranab Mukherjee to deter the generation and use of unaccounted money. Section 56(2) (viib) was added in the Income Tax Act 1961, that provided that a resident company issuing share at a premium is subject to tax under the head ‘income from other sources.’ The income generated is calculated as the difference between the consideration actually paid and the fair market value of the said share There have been five major issues raised by start-ups as well as investors on taxing of angel funding.
First, there is disagreement on the concept of ‘fair market value’. It is often difficult to determine the fair market value of the shares when the start-up is at its conceptual or development stage. Valuation of a start-up is generally determined by certified merchant bankers or chartered accountants based on company’s projected earnings as well as negotiations between the investors and the start-ups. However, an issue arises when start-ups are not able to match their initial projections and, hence, Assessing Officers, who have been given wide discretion under the Income Tax Act, reject the original valuation and reduce the ‘fair market value’ at the time of assessment, due to which premium amount on which tax is levied is rises. Further, Section 56(2) (viib) only applies to resident investors, and thus start-ups may shift to foreign investors and may ultimately be foreign-owned.
Second, the process lfor approval under Section 56(2) (viib) is criticised as cumbersome. The Central Board of Direct Taxes, in May 2018, issued a notification granting exemption to start-ups under Section 56(2) (viib) if they have approval from the Inter Ministerial Board of Certification as per the notification issued by ministry of commerce and industry in April 2018. According to the earlier notification, a start-up shall be eligible to apply for approval under Section 56(2) (viib) only if its total investment, including funding from angel investors, does not exceed `10 crore. Further, the investors subscribing the shares of the start-up must either have an average income of `25 lakh or more for the preceding three financial years or must have a net worth of `2 crore or more in the preceding financial year. For availing of such exemption, a certification of valuation by a merchant banker is required. While the notification purportedly gives an exemption, the eligibility conditions and the procedure prescribed make it too cumbersome.
Third, the procedure does not provide for any time period within which approval needs to be granted and, hence, start-ups can face delay in getting approvals. This has an adverse impact, especially when start-ups are nascent and struggling to grow their business.
Fourth, as per the notification issued by DIPP, to qualify as a start-up, a company has to be less than seven years old and must never have had an annual turnover of more than `25 crore. Further, it must not have received more than `10 crores in total from angel investors. From this, it is clear that start-ups that did well in any of their first seven years will not get an exemption. Further, it also encourages start-ups to enter into arrangements showing less annual turnover for seven years.
Fifth, the obligation of depositing 20% of the total tax demand by start-ups for filing appeal against the order of the Assessing Officer before CIT (A) needs to be relooked. It is important to note that tax notices to some start-ups demanded for around 50% of the money given by angel investors—20% pre-deposit of such substantial amount will affect the start-ups drastically.
The Union Budget is will be out on February 1, and the government should reconsider the above provision in the Budget. It should strike a balance between deterring money laundering as well as safeguarding the interest of young entrepreneurs. A proper method of valuation of a start-ups must be determined, accepted by entrepreneurs, investors as well as the government. Next, the procedure laid down for claiming exemption under Section 56(2) (viib) must be simplified. And last, the 20% pre-deposit condition for start-ups for filing an appeal must be made flexible so that they are not adversely impacted.
The author is Research Fellow (Tax Law), Vidhi Centre for Legal Polic (View are personal)