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Mumbai: The income tax department is in discussions to levy tax on start-ups that have seen a fall in valuations on the premise that the premium received by the company was more that its fair value. The news was first reported by The Economic Times on Thursday.

Is this a new tax?

This tax has been around for the last four to five years and not just for start-ups. “This is not a new tax, there is no change in the law and it doesn’t affect start-ups that have raised money from foreign funds (Tiger Global, Softbank, Accel among others). This leaves a very small fraction of Indian start-ups that would have to pay this tax and that too (only) for angel investments because a company that raised funds from a venture capital fund that is registered with Sebi would also be exempted from the tax," says Sanjay Khan who is part of the legal services team for iSpirt (Indian Software Product Industry Round Table).

That means unicorns such as Flipkart and Zomato that may have seen a fall in valuation have no cause to worry.

How does it work?

When a company is looking for its first round of funding, typically an angel or a seed round, it doesn’t have a proven business model and investments are sometimes on faith or a modelled discounted cash flow. Over a period of six to seven years, the company raises a few more rounds. Then a private equity investor comes on board. The PE investor revalues the company at half the value it was valued at in the angel round. This is when tax dynamics come into play.

Since the company has not issued shares at fair value, it will be taxed 30% on the premium, and this will be done for every round of funding received at a premium with a interest rate of 12% for delayed payments.

The tax is levied because the taxman thinks the premium is actually the company’s income.

“If a company was valued at X and raised $9 million in its previous round, but now with market forces at play its valuation falls by a third to X/3 then it will be taxed on $6 million that is now considered as its income," says Harish H.V., managing partner Grant Thornton.

“However, this tax has some exemptions. If the company is able to justify that the fall in the valuations is due to external factors ( regulatory change, business changes) it would be exempted from the tax," says Bijal Ajinkya, partner at Khaitan & Co.

“The Income-tax Rules prescribe the methods of valuation, as well as the date on which the valuation has to be considered. Also, valuation done on a current date cannot be applied to prior year, where such valuation has been undertaken as per the prescribed methods. For instance, valuation as undertaken on a specific date in 2016 which is based on specific facts, assumptions and rules cannot be applied to share capital infusion in the year 2011," adds Hitesh Sawhney, Partner - Direct Tax, PwC.

Is this good or bad news?

“There is no objective measure to provide/accept the valuation/premium argument -- the (tax) inspector is completely free to decide either way purely on his whims at any given point of time. This makes the entire process opaque and a rich vector for rent-seeking behaviour of all kinds," says Sumanth Raghavendra, founder, Deck App Technologies. His company, for instance, was asked to justify a $0.5 million equity investment in it to the taxman.

Mint reached out to a few venture capital funds who didn’t want to officially comment on the tax levy. Some, though, expressed concerns about it being bad for the growth of the ecosystem.

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