India’s entrepreneurs have been a worried lot in the past few months. Apart from trying to build a sustainable and profitable business for the long-term, they now have to run from pillar to post explaining to the Income Tax Department why investors valued their companies at a huge premium. The ghost of angel tax has returned to haunt them.
The I-T Department is demanding that start-ups pay income-tax on the share premium they receive from investors. It has issued notices to companies that have raised money from investors at the angel or seed funding stage. The angel or seed rounds are the stages of funding before a venture capital fund invests money in a start-up.
So, what’s the controversy about?
Retaining control
The I-T department is using section 56(2)(viib), which was introduced in 2012 to help detect illegal payments routed through share transactions, to extract tax from these companies. Start-ups issue shares at a premium because the founders like to keep control of their companies. If they don’t, then dilution of a founder’s equity will be higher with every round of funding.
Taking debt to grow a business doesn’t make sense when the company is trying to build a revenue stream from scratch. Some companies use instruments such as convertible debentures to raise debt funds, though these are similar to equity because the holder of these instruments eventually gets shares after a pre-determined period of time.
The exorbitant valuations at which some start-ups raise money, despite running loss-making businesses, has irked income-tax officers. Start-up founders and investors say that valuations are mostly discussed across the table, based on negotiations with investors. The television show Shark Tank is a real-life, dramatised illustration of how these negotiations take place.
Exorbitant value
At the heart of the issue is the way start-ups value their businesses. Most start-ups that raise funds use the discounted cash flow method to value their businesses. It’s a popular, tried and tested way of valuing a company. The enterprise value of a business is calculated using this method and then, to evaluate the value of each equity share. It is this method of valuation that the I-T Department has rejected in most cases where it has sought to impose angel tax on companies.
The key issue with most start-ups is that they are loss-making businesses, which makes valuations a grey area. For tax authorities, the bone of contention is that companies with large accumulated losses are being valued at a premium to their net worth. Net worth is the total assets minus total liabilities (excluding share capital and accumulated profits or losses).
But angel investors and venture capitalists argue that valuation of a company is more an art than a science. In the case of companies that don’t have a consistent revenue source, like start-ups, valuation is purely dependent on negotiations between promoters and the investor.
It is here that the I-T Department has intervened and issued notices to start-up founders and their angel investors, and is imposing heavy penalties using extensive powers available to it under the Income Tax Act.
Accumulated losses vs share premium
Put simplistically, the value of an equity share is calculated by dividing enterprise value by the total outstanding equity shares. Let’s take an example to illustrate this. After setting up his business with own savings, X approached friends and family to invest money into his retail product promotion business. X raised ₹1 crore from the investors, who valued the loss-making firm at ₹2 crore. The net worth of this company, though, was negative due to accumulated losses, as in almost all cases where start-ups raise funds in seed and angel rounds.
Using section 56(2)(viib), the income tax officer rejects the valuation, claiming it’s not at fair market value. Using the net asset value of X’s business, the income tax officer adds the premium received over and above the face value of each share issued to the company’s income. This income is taxed at 30 per cent and X’s company has to pay interest, and in some cases, penalty as well.
Hoping for respite
To assuage the fears of start-ups and to save its much-publicised Start-up India programme, the Commerce Ministry created an inter-ministerial board to approve companies that will be exempted from section 56(2)(viib). It set a threshold of the net worth for companies that could avail this exemption, and also set a threshold of income and net worth for the angel investors, to avoid questions on their investments in start-ups. But this didn’t work. Even angel investors received notices from the department to explain the source of their income.
The department has been issuing notices for the past three years. These notices are usually issued before December to avoid them being time-barred under the law (assessment order has to be raised within 18 months of the end of the pertinent assessment year). After multiple representations by various groups, the I-T Department has asked its officers to stop taking coercive action against companies under this section.
Multiple rounds of circulars later, the Central Board of Direct Taxes, the umbrella body that administers income tax law in India, has formed a working group to sort out this issue as soon as possible. Entrepreneurs are holding their breath, hoping for a reprieve in the next week or so.