Self-employment has been one of the pillars of the current government's job creation agenda and it has been working to create a supportive eco-system for start-ups. Prime Minister Narendra Modi announced the start-up India initiative in his Independence Day speech in 2015. The action plan is based on three pillars of (a) simplification and handholding, (b) funding support and incentives, and (c) industry-academia partnership and incubation.
However, it has not been a smooth ride for startups, with tax disputes around the valuation of investments, popularly known as angel tax, is one of the key concerns. As per a recent Indian Venture Capital Association (IVCA) survey, the income-tax department has sent notices to almost 2,000 startups, seeking information/demanding tax on investments received by them on grounds of excessive valuation of shares.
The controversy arises in cases where a closely held company issues shares to a resident investor for a consideration in excess of the fair market value (FMV). The excess consideration is liable to tax in the company’s hands as ‘income from other sources’. Accordingly, the capital /premium invested by the investors in startups in excess of the startup's FMV is taxed under this provision and is referred to as 'angel tax'.
The provision seeking to tax excessive valuation of shares was introduced in 2012 to address cases of tax abuse and money laundering. The primary objective was to curb such practices where shares of a company were issued at a premium, which was eventually returned to investors in cash through other modes. This anti-abuse provision, however, has been applied by the tax authorities without looking into the merits/genuineness of the transaction.
Investments received by startups were caught under these provisions. This has hurt startups as their initial investments are driven by the 'perceived potential' of the 'idea' and 'trust' in the capability of the promoter, rather than fundamentals of past sales or expected growth.
Thankfully, the government has been cognizant of this pain point and has made efforts to address the concerns. The Department of Industrial Policy and Promotion (DIPP), now known as Department for Promotion of Industry and Internal Trade (DPIIT), in 2016 notified that the angel tax provisions shall not apply to investments in eligible startups fulfilling conditions prescribed by the DIPP. Subsequently, notifications were issued in 2017, 2018 and in January 2019, amending the definition of startups, capital threshold limit for startups, and net worth/ income threshold limits for investors for availing the exemption.
The procedure for seeking approval was also amended and simplified with the DIPP's notification of January 2019, vesting the Central Board of Direct Taxes (CBDT) with the authority to grant approval for exemption from angel tax. Still, there was much ground to be covered.
Paying attention to the representations from startups and the investor community, the DPIIT on February 19, 2019, notified major changes. A significant step has been to exempt startups with an aggregate paid-up capital (including share premium) of up to Rs 25 crore from angel tax.
Also, investments by non-residents, venture capital funds and the specified listed companies would not be counted for Rs 25 crore capital threshold limit. In other words, startups would be eligible to raise capital from such investors without any cap, thereby allowing added sources of funds without triggering the angel tax.
Further, to address the concerns around obtaining CBDT approval, the new notification replaces this requirement with an upfront exemption based on a self-declaration to be filed by the startup, stating that it has fulfilled the conditions for claiming angel tax exemption. The declaration includes an undertaking specifying that the startup shall not invest funds for a period of seven years in certain specified restricted assets, such as land and building, shares and securities, motor vehicles, jewellery, archaeological collections, drawings, paintings, sculptures, any work of art or bullion, etc.
The other significant change is in the definition of a startup. An entity will be considered as a startup up to a period of 10 years from the date of incorporation (as against seven years at present). The startup’s annual turnover threshold during the eligibility period has also been increased to Rs 100 crore in any of the years (as against the current limit of Rs 25 crore).
However, the new framework has inserted restrictions on investments by startups in certain ‘non-business’ assets. This includes investments in assets such as land and building (except for use of business), onward lending (except when lending is a substantial part of the business), investment in shares and securities, purchase of expensive motor vehicles, etc. This restriction applies for a period of up to seven years from the end of the financial year in which shares are issued. Most significantly, non-compliance with this requirement shall result in revocation of the exemption with a retrospective effect. The key intent is to avoid misuse of these beneficial provisions.
The recent changes may pose some challenge in certain cases like where investments have already been made in such restricted assets. Investment of temporarily idle funds in shares and securities or investment of funds in entities for the forward or backward integration in the supply chain are some of the usual and genuine business activities that would get impacted by this restriction. A clarification that these conditions should apply prospectively would help in mitigating any dispute and litigation on this account.
In a nutshell, it’s a welcome move, where the government has attempted to address most of the concerns of the startup community. This would go a long way in ease of doing business in India. However, there may be some teething issues, given the manner in which restriction on the use of funds for certain category of assets has been introduced.(Vikas Vasal is national leader tax–Grant Thornton India LLP. Gaurav Mittal and Sarang Dublish contributed to this article)