Context

• Start-ups have come under the scrutiny of tax officials for having raised capital above the fair value of their shares.
• Section 56(2)(viib) of the Income Tax Act provides for taxation of the share premium that is above the fair valuation of shares as “other income”.

About

What is Angel Tax?

• It is a 30% tax that is levied on the funding received by startups from an external investor. However, this 30% tax is levied when startups receive angel funding at a valuation higher than its ‘fair market value’. It is counted as income to the company and is taxed. Angel tax was introduced in 2012, with the purpose of keeping money laundering in check.

Ideology behind angel taxation:

• Start-ups’ problem of angel tax stem from an anti-abuse provision introduced in the Income Tax Act in 2012 to curb the practice of politicians accepting bribes in the guise of share premium in unlisted companies set up by them.
• Tax officials prefer to value these enterprises based on their net asset value, companies tend to be valued based on estimates of their future earnings.

Why is Angel tax problematic?

• There is no definitive or objective way to measure the ‘fair market value’ of a startup. Investors pay a premium for the idea and the business potential at the angel funding stage. However, tax officials seem to be assessing the value of the startups based on their net asset value at one point. Several startups say that they find it difficult to justify the higher valuation to tax officials.
• In a May, 2018 notification, the Central Board of Direct Taxes (CBDT) had exempted angel investors from the Angel Tax clause subject to fulfilment of certain terms and conditions, as specified by the Department of Industrial Policy and Promotion (DIPP). However, despite the exemption notification, there are a host of challenges that startups are still faced with, in order to get this exemption.

Income Tax notices

• One of the reasons put forward by the Income Tax Department to send such notices is to get information for distinguishing the genuine startups from the bogus ones. The notices essentially fall under two brackets: Notices under section 56(2)(viib) of the Income Tax Act, which is called income from other sources. This section states that any excess consideration received by a company will be treated as its income if it issues shares to a resident at a price which exceeds the fair market value of the shares. The section is invalid if consideration is received from venture capital companies, venture capital funds or a class of persons notified by the government.
• Notices under section 142(1) of the I-T Act: An assessing officer sends a notice under this section to procure additional documents needed to carry out a scrutiny assessment. The assessing officer has to complete an assessment within 21 months of the end of the assessment year or 33 months of the end of the financial year.

Government’s stand

• Earlier in the year, the Department of Revenue (DoR) had issued a notification directing assessing officers not to take coercive steps on recovery of angel tax against registered start-ups. But unregistered startups who have already raised angel investment, may still be under the scanner of the income tax authorities.
• Recently, CBDT issued a statement that no coercive action related to tax recovery would be taken till an expert panel resolves this issue. CBDT recognizes that startups are going to bring a lot of innovation to the country and, therefore, have to be supported in every possible manner.

A panel of eminent experts from IITs and IIMs will be formed soon to prepare a new framework for recognition of startups.

Global practices:

• China: Baidu, Tencent, and Alibaba are a few well-known names that have emerged from the Chinese market. Preferential tax policies allow 70 per cent of total investment to be deducted from taxation two years after investment in high-tech start-ups
• Singapore: Tax incentives are available to start-ups and investors, even offering qualifying start-ups up to Singapore $200,000 tax exemption on their first three consecutive years of assessment (YAs).