Opinion | The decline of tax demons and the ascent of angels

On 23 August 2019, finance minister Nirmala Sitharaman, while announcing the non-applicability of Section 56(2)(viib) of the Income Tax (I-T) Act, 1961, popularly referred to as “angel tax” on startups registered with department for promotion of industry and internal trade (DPIIT), reassured entrepreneurs that the government was already sensitized to the importance of the startup ecosystem and was taking all possible steps to boost confidence of investors and other players in the startup sector.

Recently, the I-T department’s sudden move to deduct a substantial amount from the accounts of two startups, Babygogo and Travelkhana, caught media attention, setting off a debate over taxation under Section 56(2)(viib) of the I-T Act.

We shall not get into the merits of the aforesaid case, or claim that the aforesaid recovery was in relation to that section. However, irrespective of the factual position or law involved, the Babygogo and Travelkhana fiasco attracted sharp criticism on levying “angel tax” on India’s startups. Further, many startup founders have been asked to pay a huge part of their funding as tax, angels have also received multiple notices asking them to furnish details of their sources of income, bank account statements and other financial data. All these events created some anxiety for startups. In a measure to resolve the issue, the ministry of commerce and industry, through the DPIIT, issued an “initial notification” on 19 February to exempt startups from angel tax on fulfilling certain criteria mentioned in the document, which followed an announcement by the finance minister.

The angel tax was introduced in the Union budget of 2012 presented by the then finance minister Pranab Mukherjee, and its objective was to curb money laundering via small companies. It has come to be called by its name since it largely impacts angel investments in startups. Soon after, this tax became part of the I-T Act, under which, inter alia, if a company in which the public has no substantial interest receives (in the previous year) from any person, who is a resident, any consideration for an issue of shares that exceeds their fair market value, then the difference between the aggregate sum received and the fair market value shall be considered “income from other sources”, and so the recipient company would have to pay tax on the differential amount (which is taxable at a rate of up to 30%, plus the applicable cess and surcharge). It should be noted that this angel tax is not applicable in case investments are made by any non-residents or venture capital funds. The issue, which irked startups, was that for the purpose of investment, the valuation of a startup’s equity is usually done on the basis of commercial negotiations with investors and, since this exercise is generally based on projected earnings, the figure arrived at could be higher than what is obtained from the valuation formula stipulated under the Income Tax Act. If the difference is held taxable, the burden could be very high.

Startups have demanded that the discounted cash flow method of valuation be used to calculate angel tax, instead of the net asset value method, though even that may not capture the true value of a new company. The startup community got wind of the issue once the income tax department started sending some firms tax notices under Section 56(2)(viib) of the I-T Act.

The matter has been given a rethink. In stage one, the initial notification provided that an entity, which is registered as: (i) a partnership firm, (ii) a limited liability partnership or; (iii) a company; and (a) has not completed 10 years of its incorporation; (b) turnover of the entity for any of the financial years since incorporation/registration has not exceeded ₹10 crore; and (c) the entity 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, could seek recognition as startup from the DPIIT. Further, such a startup is eligible for angel tax exemption only if the aggregate amount of paid-up share capital and premium of the recognized startup after the issue or proposed issue of shares, if any, does not exceed ₹25 crore and fulfils certain other criteria given in the notification.

On 23 August, while briefing the media on the steps taken by the government to address the financial slowdown in India, Sitharaman announced that section 56(2viib) of I-T Act shall not be applicable to startups registered with the DPIIT. Such startups will not have to fulfil any criteria as per the initial notification, other than DPIIT recognition, to avail of exemption from angel tax. The finance minister also said that no coercive action will be taken to recover tax demands and a dedicated cell will be set up under a member of the Central Board of Direct Taxes to address the issues faced by startups.

Indian startups have high growth potential and need regulatory support for their steady growth. The recent announcement by the finance minister is a confidence booster for the country’s startup ecosystem. As for the proposed panel, we will have more clarity on its power and functions once an official notification is issued on it.

Abir Dey and Satyadarshi Kunal, principal associate and senior associate, respectively, at Cyril Amarchand Mangaldas also contributed to this article

Cyril Shroff is managing partner at Cyril Amarchand Mangaldas