Given the prime minister’s emphasis on Startup India, it is particularly odd to see the taxman levying a tax on the premium they get on their valuation from investors. Start-ups are a bet on the future and investors pay a premium for this—that premium, then, is invested in the business which, if you’re lucky, works out.
Though the premium is a balance-sheet entry, for some years now, taxmen have been trying to treat this as income—they use Section 56(2) (viib), introduced in the I-T Act in 2013 for this, since that allows any payment above the fair-value to be taxed as income. The problem, however, is that it is impossible to figure out what the fair value is—indeed, the fair value also changes from time to time, depending upon business conditions and investor spirits. While the number of such Section 56-cases were limited in number earlier, according to a report in The Economic Times, around 100 orders have been passed by the taxman between November 30 and December 15 on this basis. In these cases, since valuations have dropped a lot over the past year, the taxman is using the current valuation as a base, and claiming the amount paid over this in the past has to be treated as the start-up’s income.
In most cases, this wouldn’t really matter since the orders are usually challenged anyway. But in the case of start-ups that are both stretched for manpower and cash, wasting the promoter’s time in fighting a tax case distracts from the main business in a big way, apart from the ignominy of being considered a tax-thief. More worrying, in this context, is the taxman’s recent FAQs on the tax dispute resolution scheme—under this, if an entity wants to settle a case, such as the Section 56(2) one, it has to withdraw any pending appeal or arbitration first. Imagine the plight of a firm which withdraws its petition against the taxman and then finds it has to pay a tax to settle the case which it regards as unfair in the first place.
At a time when start-up funding is drying anyway—funding has halved to $3.7 billion in April-November 2016 over that the previous year—such tax policies are only going to make things worse. It will also ensure start-ups who have the means will prefer to register in locations like Singapore.