What startups should do to deal with the Angel Tax shocker

Two years ago, the government launched a series of steps to support startups to foster economic development and create more jobs. The aim was to harness innovative ideas and get them funding from the government itself or from a bunch of angel investors, to create more first-generation entrepreneurs. Tax sops were also announced to attract talent.

In recent months, several startups and angel investors have been served notices by the income tax department, demanding tax on investments. This was widely covered by the media because of the potentially huge setback for startups.

Startups typically require funds from early stage, or angel, investors who provide the first significant chunk of money and mentoring to help founders prove their technology or product and hit milestones needed to attract even bigger investments from venture capitalists later on. Angel investment normally comes on premium valuation which is based on futuristic earnings base. Angel tax is a levy applied as per section 56(2) of Income Tax act 1961, which is the difference of premium as considered higher than the fair value of shares. A tax officer typically sees the valuation on which angel investors put money as higher than the fair market value and thereby issues a show-cause notice to levy a tax on the said excess value. This tax is referred to as angel tax. This section applies to only unlisted company shares that are not widely held.

Almost all startups get funding through angel investors in their first year of operations. Their net operating results in that year are normally operational loss as the invested amount is put to technology or in the payroll of people working as such.

Hence, when they file their tax returns, these returns show a loss from business operations while the infusion of capital is shown at the premium. Therefore, in a random check analysis, this premium-led share capital is considered as abnormal and tax scrutiny notices are sent to the startups to explain the basis of valuation with the valuation report, to come clean. This section of 56(2) is draconian and it is used sometimes to harass startups, which are always starved for liquidity and funds.

Such tax notices will definitively impact startup activities, including investments in these businesses. The government had earlier eased the tax provision by building safeguards, although it could not ease the pain of startups. As start-ups are valued based on the business potential of their ideas, which could change with the time, sometimes it’s difficult to justify the share premium received. In view of the fact that the ratio of successful startups is very low — the numbers could as few as five in 100 startups — these notices become a pain.

Consequently, angel investors shy away from promoting big ideas and would prefer to invest in phase two when the initial funding is already there and the project is shaping up. At the same time, good projects will still mushroom. Over the next couple of years, when this tax provision will likely settle down, the negative impact on fresh investment will die down.

Once a tax notice is received by a startup, it should consult its chartered accountant (CA) and keep all relevant papers submitted to the tax officer. The tax officer will mainly need the valuation report done by a requisite professional, now by an approved valuer or by a merchant banker.

The valuer should ensure the projections given by management are validated by him from related documents, correspondence and agreements. This validation and the method of valuation then cannot be challenged by a tax officer. The Central Board of Direct Taxes (CBDT) has also issued a circular that a startup cannot be harassed on such notices and it be given adequate opportunity to present its facts and documents.

Given a choice, a startup can make the valuer also available for examination by tax officer so that the genuineness of the valuation cannot be questioned. It is expected that a startup will hire a proper tax consultant who is knowledgeable in this field.

In view of the notices issued, the government also feels that it is creating a negative impact, which was not the intent in introducing this section in 2012. The government issued a clarification that no coercive action will be enforced until an expert panel resolves this issue.

The issue of shares at a premium is a common practice in new-age enterprises. The CBDT has mentioned that it recognise that startups are going to bring a lot of innovation to the country and therefore have to be supported in every possible manner. Government officials in their joint meeting decided to create an expert committee on startup taxation with members from institutions such as IIM and IIT.

Laws are generally made to protect corrupt practices. This provision was introduced like an anti-abuse provision to curb the practice of politicians accepting bribes in the guise of share premium in unlisted companies set up by them. However, the new-age entrepreneurs are trapped unknowingly and are struggling to deal with such notices, with little cash flow.