February 09, 2018

TaxBuzz : Stay on ‘Angel tax’ levied on start-ups - Notification by CBDT

Section 56(2)(viib) of the Income Tax Act, 1956 (“the Act”) provides that where a closely held company issues shares at a price more than the fair market value (“FMV”) of such shares, the amount received in excess of FMV will be  deemed as ‘income from other sources’.
Explanation to the aforesaid section read with rule 11UA of the Income Tax Rules (“the Rules”), prescribes the method for determination of FMV of such shares, which, inter alia includes valuation as per the Discounted Free Cash Flow (‘DCF’) method determined by a merchant banker or an accountant. DCF method of valuation encompasses determination of the FMV of the shares of company on the basis of the estimation of future profits from the business, conceptualized by the company.
If projections of future profits from a business idea are high, the same could result in higher FMV of the shares of a company at which an investor could be willing to invest.
In such a situation, the premium received on issue of shares, especially in case of a newly incorporated company, shall be higher than face value of newly issued shares, which gets covered within the scope of section 56(2)(viib) of the Act.
In the tax assessments of such companies, in recent times, the assessing officers in majority cases did not accept the valuation of company as per DCF method and alleged such value to be higher than FMV of shares, and brought the difference to tax as income under section 56(2)(viib) of the Act, raising huge tax demand on such companies.
Having regard to the intent of avoiding tax recovery in genuine cases of fresh issue of shares to investors, CBDT has issued Notification no. F.No. 173/14/2018 dated 06.02.2018 directing the assessing officers to refrain from taking coercive measures to recover outstanding demand arising out of additions being made under section 56(2)(viib) of the Act after rejecting the valuation report furnished under Rule 11UA(2) in case of “Start Up”. Further, the Board has directed for undertaking necessary administrative steps for expeditious disposal of appeals involving aforesaid issue pending with the Commissioner (Appeals), preferably by 31.03.2018.
Comments / Observations
The aforesaid Notification has come as a necessary relief to start-up companies, which have been defined by the Ministry of Commerce and Trade vide Notification no. G.S.R. 501(E) dated 23.05.2017 as follows:
“(a) a company incorporated as a private limited company (under the Companies Act, 2013), or a partnership firm (under the Partnership Act, 1932) or a limited liability partnership (under the Limited Liability Partnership Act, 2008) in India;
(b)   a company shall be considered to be a startup, up to seven years from the date of its incorporation/ registration;
(c)    a company in the biotechnology sector however, shall be considered to be a startup up to ten years from the date of its incorporation/ registration;
(d)   a company shall be considered to be a startup, if the turnover for any of the financial years since incorporation/ registration has not exceeded Rupees 25 crores; and
(e)   the company is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.”
While the aforesaid notification is a welcome move by CBDT, the applicability of the same is restricted to only companies falling in the definition of ‘Start-up’.
In a further move, the government is considering a proposal to exempt investments made by recognized angel investor groups in Start-Ups, from such ‘angel tax’. A committee has been set up under the Securities and Exchange Board of India (SEBI) to form a framework for regulating the angel investments. (Source:http://www.livemint.com/Companies/Govt-may-exempt-funding-by-recognized-investors-in-startups.html)
Such initiative may extend the benefit of exemption to angel investors, as a part of the larger exercise to regulate angel investor community. This move comes in line with the budget speech of the finance minister, wherein additional measures to strengthen the environment for growth and successful operation of alternative investment funds in India was strongly emphasized.
If a company does not meet the test of ‘Start-up’, such as a new company incorporated as a public limited company or an existing company with turnover exceeding Rs. 25 crores, coming out with rights issue for a new business idea, etc., such company(ies) will not strictly be covered within scope of the aforesaid Notification and will face not only litigation but also recovery of the outstanding demand.
It would be preferable for CBDT to expand the scope of the present Notification to all genuine cases of investment, instead of restricting the scope to only Start-Ups or in future, to recognized angel investors.
For any details and clarifications, please feel free to write to:
Mr. Gaurav Jain: [email protected]