ANGEL TAX BACKDROP AND COMPREHENSIVE A N A L Y S I S

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1 BACKDROP AND COMPREHENSIVE A N A L Y S I S

2 STEEP FALL IN ANGEL FUNDING TO STARTUPS The number of angel and seed funding deals halved to 435 in 2017 from 901 in 2016, according to a report. The total disclosed value of these deals also fell sharply to $245 million from $374 million.

3 INDEX 1. Foreword 2. Overview 3. Background 4. What does the law says Section 56 (2) (viib) 5. Challenge Faced by Government 6. Problems faced by Start-ups 7. Measures Already taken by the Government 8. Way forward

4 FOREWORD This report is created to give comprehensive overview of angel tax, and also problems faced by our nascent Startup ecosystem as its consequences. The Indian Startup eco-system will only thrive when new ideas are nurtured at the very initial stage by providing right funding and mentorship. India needs to develop 1 million entrepreneurs for it to be become economic super power, raising per capita income of each one of our people. More and more angel investment should happen from domestic individual for the ecosystem to grow in real terms. Simplifying rules around Angel funding will go way in achieving that. Alok Patnia CEO and Managing Partner Taxmantra Global

5 FOREWORD Angel funding is the backbone of any emerging start-up ecosystem. Entrepreneurs thrive on angel investments at the right time and I have seen many a start-up idea die for want of monetary support. I hope the government will look at abolishing angel tax, which will go a long way in helping entrepreneurs do what they do best ie create and thrive. Shradha Sharma Founder and CEO at YourStor y.com

6 Overview Angel Tax refers to section 56 (2) (viib) of the Indian Income Tax Act, 1961, wherein the Income Tax Authorities are demanding additional taxes from Start-up Companies who have received funding from Indian Resident Angel Investors at a valuation higher than what can be perceived for an early stage start-up venture. Background Once Bitten, Twice Shy is a perfect proverb to define the current mindset of the Income Tax Authorities, Central Board of Direct Taxes (CBDT) and even the Ministry of Finance. In the Income Tax Appellate Tribunal, Kolkata, Departmental Representative, during a course of proceedings in the Income Tax Appeal has explained the modus operandi of conversion of black money into white through the medium of shell companies. He explained that the entire episode is completed through three levels.

7 Background In the first level, Company A is incorporated on papers, which does not carry out any substantial business activity. Suppose, this company issues 10 shares to another dummy company, say X with face value of Rs.1/ at a premium of Rs.49, raising its share capital to Rs.500/-. The sum of Rs.500/- standing on the liability side of the balance sheet of company A is equalized with Investment in shares of Company B, which is again a paper company, at a much higher price than its real worth. Company B, in turn, gets Rs.500/- and invests the same in the shares of another dummy private limited company C, again at a huge undeserving market price. This process goes on as the same amount of Rs.500 is rotated through various dummy companies eventually showing their capital and share premium at Rs.500/- represented by investment in shares of other dummy companies by equal amount of Rs.500/- subject to the deduction of certain expenses incurred or some petty income earned.

8 Background In the second level, a person, say Mr. Y, intending to convert his black money into white enters into a deal with company X, who is shareholder of company A. Company X sells its shares of Company A with the purchase price of Rs.500 at its real worth, say, Rs.6 per share. Mr. Y purchasing shares of company A for apparent consideration of Rs.6, pays Rs.494/- in cash and, thus, acquires all the shares of Company A with apparent investment of Rs.6/- and real investment of Rs.500/-. Mr. Y retains these shares for a period exceeding one year. In the third level, the operators who have created this web of dummy companies assist Mr. Y in selling the shares of company A at Rs.500/- through fictious transactions entered into with Mr. Z. Mr. Y realizes Rs.500/- in cash and brings this amount into circulation. Profit of Rs.494/- [Rs.500(sales price) minus Rs.6 (apparent purchase price)] earned by Mr. Y is not chargeable to tax in terms of section 10(38) as it arises `from the transfer of a longterm capital asset, being an equity share in a company. That is how, Mr. Y converts Rs. 494/- from black to white.

9 The shares of company A are sold through operators to Mr. Z, who is interested in purchasing share loss. Mr. Z treats the shares of company A either as his stock in trade or Investment, depending upon his requirement. If these shares purchased for an apparent consideration of Rs.500 are held by Mr. Z as stock in trade, then at the end of the year, he will value such stock in trade at market price, say at Rs.10. By doing so, he will show a loss of Rs.490 from the valuation of shares, which will be adjusted against his normal business income to this extent. If Mr. Z treats these shares as Investment, then the operator will help him in selling the shares at their market price of Rs.10. Loss from the sale of Investment, being loss under the head `Capital gain, will be set off against any other capital gain genuinely earned by Mr. Z. This is the entire mechanism by which Mr. Y, who purchased the shares of Company A has succeeded in converting his black money of Rs. 494 into white. In the same manner, Mr. Y1 and Mr. Y2 etc. convert their black money of Rs.494 into white by purchasing the shares of Company B and Company C etc. The end result is achieved by operators by routing the transactions of shares through several layers of companies, thereby giving colour of genuineness, which in reality is nothing but a camouflage

10 CHALLENGES FACED BY THE GOVERNMENT

11 Challenges faced by Government With conjunction of black money hoarders, finance professional and government officials, a practice was developed wherein, closely held companies could bring in undisclosed money of promoters/directors or even third parties (For a commission) by issuing shares at high premium which is normally over and above the book value of share of the company. Moreover in case of many closely held companies and even in new companies promoters used to issue share at premium with the main purpose of keeping share capital low, yet capital base stronger so that breakup value and market value is high. This leads to advantage of low cost of servicing share capital and also improved prospects to issue share at premium in future by way of initial issue of offering by promoters. One more practical advantage was to save on account of cost of fees payable on increase of authorized capital.

12 Challenges faced by Government When shares are issued at premium, number of shares and authorized capital increase lesser in comparison of capital raised by way of capital and premium. These provisions are deeming provisions as otherwise share premium and capital is a capital receipt which cannot be taxed as income. As per a media report A little over 11,281 Companies are registered at 148 addresses, an average of 76 each. Seven of the top 10 most common addresses were found in Kolkata. Income Tax Department started investigations and crackdown on such shell companies. It is this network of shell companies and this shabby but remunerative business of conversion of black money to white, the then Finance Minister of India, Mr. Pranab Mukherjee, in Budget 2012 effective from Assessment Year (AY) , introduced section 56 (2) (viib), which is now also termed as Angel Tax.

13 WHAT DOES THE LAW SAY SECTION 56 (2) (Viib)

14 Section 56 (2) (viib) Clause (viib) of sub section (2) of section 56 was inserted vide finance act, 2013 w.e.f i.e. for A. Y to provide that where a closely held company issues its shares at a price which is more than its fair market value then the amount received in excess of fair market value of shares will be charged to tax in the hand of the company as income from other sources. Clause (viib) is read as under:- Where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:

15 Section 56 (2) (viib) Provided that this clause shall not apply where the consideration for issue of shares is received (i) by a venture capital undertaking from a venture capital company or a venture capital fund; or (ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf. Explanation. For the purposes of this clause, (a) the fair market value of the shares shall be the value (i) as may be determined in accordance with such method as may be prescribed; or (ii) as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature, whichever is higher;

16 Section 56 (2) (viib) (b) venture capital company, venture capital fund and venture capital undertaking shall have the meanings respectively assigned to them in clause (a), clause (b) and clause (c) of Explanation to clause (23FB) of section 10]; The law clearly says that in case of equity or preferential investments in a Company, anything over and above the Fair Market Value (FMV) of the Shares shall be taxable as Income From other sources for the Company. Also, the FMV shall be the higher of the valuation as per prescribed rule 11UA or to the satisfaction of the Assessing Officer (AO). Rule 11UA talks about the computation of book value of the shares as computed by the defined formula or as per Discounted Cash Flows (DCF), certified by a CA or merchant banker.

17 PROBLEMS FACED BY STARTUPS AND ANGEL INVESTORS

18 which the tax is to be levied. Problems faced by Startups and Angel Investors Ideally, if FMV as determined based on future projections and Discounted Cash Flows (DCF) and certified by a CA or a merchant banker, even if higher than the actual book value or even what has been construed by the Assessing Officer, should stand good and 56 (2) (viib) invoked, only if investment is at a valuation higher than the DCF valuation. However, the main controversy is in the concept of 'fair value'. Investors value a company based on its potential and future capacity vouching on its founders and team,overall idea, scale, footprint, GMV, growth rate, revenue and run rate. However, problem arises when the performance of the company doesn't match its initial projections and the IT department due to the benefit of hindsight invalidates the original valuation, thereby, reducing its 'fair value' at the time of assessment and increasing the premium amount on

19 Problems faced by Startups and Angel Investors Startups work on certain presumptions and each valuation is done after rounds of negotiations, valuation reports, bankers report and several other regulatory compliance between the company's promoters and the investors. In fact, there can be circumstances that the company is struggling to stay afloat and its valuation would have decreased anyways. But that doesn't invalidate its original projections. There are several reports that suggest that almost 80% of startups fail within the first five years. Several founders and investors have been questioning the rationale of the IT department on asking startups to pay tax on the amount they raise 2-3 years back irrespective of whether they made profits or not. Taxing profit on the capital invested by investors, or the profits of the company is fair but taxing the capital raised doesn't seem logical. "Whether it is share capital or share premium that is raised by the company, it is still capital received. It should not be treated as revenue income." The problem further aggravates as the IT department is not just

20 asking for 30.9% tax, but the interest and then also raising demands for penalty for non-payment of tax, killing all the motivation of starting up and generating employment for the Country. Words like Start-up India, Make in India and Digital India, seem to be jokes with such Draconian law. The rationale of this law was to address the issue of money laundering wherein people were taking up shares at a premium for very little equity and using this mechanism to convert black money to white. But the big question remains that can all investors be brushed in the same colour due to a handful of black sheep? The underlying problem seems to be the problem in revenue recognition policy of the Income Tax department. The IT officials have targets to meet for the revenue collection, just like sales people in companies. On top of that, if they book the company by sending them a demand notice, the specified amount becomes a part of their revenue and its an easy way to meet their targets.

21 MEASURES ALREADY TAKEN BY GOVERNMENT

22 Measures Taken by Government Start-up India Initiative The Startup India Initiative currently provides the following benefits to a startup: 1. Tax exemptions on income tax for three years 2. Tax exemption on capital gains and on investments above fair market value (angel tax) 3. Self-certification and compliance under nine environmental and labour laws 4. Startup patent application fast track, and up to 80 percent rebate in filing patent 5. Rs 10,000 crore fund of funds for investment in startups through SEBI registered Alternate Investment Funds (AIF) 6. Rs 2,000 crore credit guarantee fund 7. Winding up company in 90 days under Insolvency and Bankruptcy Code Public procurement in all central government ministries departments

23 Start-up India Initiative However, it has not benefited startups at large. As per the Startup India status report dated October 20, 2017, available at the Startup India website of the Government of India: 74 startups were approved by the Inter-Ministerial Board to avail tax benefits. Of the Rs 10,000 crore fund of funds, Rs 600 crore has been released to SIDBI with a total commitment of Rs crore to 17 AIFs. A total of 75 startups have been funded through AIFs. Approvals from DIPP, and then from IMB, are turning out to be a time taking process, and created blockades. The approval should be more system-driven and automatic. Also, blanket tax benefits (as available for startups in Singapore) should be the way forward. The requirement barrier created in the definition of a startup creates scope for judgement and red-tapism.

24 Amendment in the Union Budget 2018 The provisions under section 80-IAC provides deduction to eligible start-up with respect to profits and gains derived from eligible business upto 100% for three consecutive assessment years out of five years at the option of assesse in accordance with and subject to provisions of said section. A comparative study of the criteria to be fulfilled under present scenario and the changes proposed in Budget is presented below:

25 Amendment in the Union Budget 2018 Present Scenario (i) In order to avail the benefits of section 80-IAC, the start-up should have been incorporated on or after 1 st April 2016 and before 1 st April (ii) The turnover of the business should not have exceeded Rs 25 crore rupees in any of the previous years from 1 st April, 2016 to 31 st March, (iii) The word eligible business includes innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property. Proposed Changes in Budget-2018 The benefits has been extended to the start-ups incorporated even after 1 st April 2019 and before 1 st April The requirement of turnover of Rs 25 crore rupees has been applied to seven previous years commencing from the date of incorporation. The definition of eligible business has been expanded to the business engaged in innovation, development or improvement of products or processes or services, or a scalable business model with a high potential of employment generation or wealth creation. As the amendment will come into effect from 1 st April 2018, it will surely impact the major start-ups who are involved in business of innovation and development of products and shall benefit the start-ups commencing their businesses even after 1 st April As the definition of startups have been eased out to a further extent, the start-ups who are able to get the Start-up India registration shall also save themselves from the Angel Tax

26 No Angel Tax on Start-ups with up to 10 Cr Funding As per certain media reports, The Department of Industrial Policy and Promotion (DIPP), is working on an amendment and shall notify the same, wherein, the start-ups incorporated prior to 2016 (Currently Income Tax benefits are available only to start-ups incorporated after 2016 and who have obtained approval from DIPP and Inter Ministerial Board) and have raised funding of up to Rs. 10 Cr, shall be exempted from the Angel Tax. However, the official notification is still awaited.

27 Circular from Central Board of Direct Taxes (CBDT) The CBDT has directed the taxman not to undertake coercive steps in recovering pending taxes from startups under a specific provision of the Income Tax Act, a move aimed to help budding entrepreneurs in the country. The move assumes significance as startups in the recent past had flagged their grievances to the government regarding angel tax provision, which, they considered, was not friendly to them. The Central Board of Direct Taxes (CBDT), in a circular to all the field offices of the department, said it has come to its notice that in recent times, a specific provision (determining of fair market value of shares) of the I-T Act is being invoked in the case of startups, which had otherwise raised a genuine investment on the basis of their idea. In view of this no coercive measure to recover the outstanding demand would be taken, it told the assessing officer (AO). The board directed the taxman to take necessary steps for expeditious disposal of appeals of such firms pending before the first appellate forum of the officer of the Commissioner (Appeals), by March 31 this year. The directive would help startups in effectively tackling the issue of angel tax the taxing of investments made by angel investors in such newly raised and innovative idea-based companies.

28 TAXMANTRA S TAKE AND THE WAY FORWARD

29 Way Forward Ensuring fair assessment A better way would be for senior members of the department to lay down detailed parameters for fair assessments, before making such additions to income, and to check the genuineness of the transaction. Only then should the claim in the notices be allowed to be accounted as revenue, and not merely by raising a demand notice. Otherwise we will not only discourage entrepreneurs but will also add on to an already long queue of tax litigation. Laws such as these especially for fledgling companies will put India on a back foot and kill the motivation in entrepreneurs to start-up in the country. The government is moving in the right direction by moving toward e-assessment with no human intervention in the whole process of communication. However, practical difficulties are not allowing this process to thrive. The Income Tax portal will have to be smarter and more user friendly to take this to the next level. Also, the discretionary powers of the Assessing Officer will have to be taken away and process driven approach to assessment should be taken up.

30 Way Forward Simple Registration of Angel Investors In any economy and ecosystem, the role of domestic and traditional businessmen and investors cannot be undermined. In the nascent stage of the Indian Start-up econ-system many old and renowned business houses and High Net-Worth Individuals turned into Angel Investors, mostly in Individual capacity. However, with lack of clarity on taxation front and lot of notices flowing from the Income Tax Department, not only to start-ups but also to Angel Investors have made the Angel investors skeptical to Investing in Start-ups in India. The right way perhaps should be to ask angel investors to register in the Income tax portal with Tax residency certificate or PAN Card number and other details. The existing registration as an Alternate Investment Fund (AIF) or a Venture Capital (VC) firm is a very long and expensive process. It takes atleast 3-4 months and involves government fee itself in lakhs of rupees and it also several approvals from different regulatory authorities, making this nonviable for angel investors to get this registrations.

31 Way Forward Simpler and more process driven Start-up India Registration Again, the discretionary powers of DIPP or IMB for granting Start-up India registration for income tax benefits should be more automated and process driven rather then giving discretionary powers to the officers to determine if the start-up is innovative or not or whether it would generate enough employment or not. The Government is doing its bit and the Country and the Start-up ecosystem has come a long way in last few years. However, a lot still has to be done and creating the conducive environment for both budding entrepreneurs and domestic investors is very important.

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35 LEADERSHIP TEAM ALOK PATNIA CEO & Managing Partner Taxmantra Global Alok is the CEO and Managing Parter at Taxmantra Global Network Firms. He is a Fellow Member of the ICAI (FCA ), an alumnus of St. Xavier s College, Calcutta, with post qualification exposure in KPMG and Ernst & Young. He has authored more than 2K blogs on Taxmantra.com and also contributes to leading platforms like YourStory.com, Moneycontrol.com. RAHUL AGARWALLA VP Operations- India (South) Taxmantra Global Rahul serves as VP Operations at TaxMantra Global. He is a Fellow Member of the ICAI (FCA), and holds a Diploma in Information Systems Audit from the Institute of Chartered Accountants of India, having 10 years of experience in handling income tax Search Seizure and Survey assessments, Appeals, Regular Assessments and other litigation and departmental proceedings relating to Income Tax Act, Service Tax, VAT and International Taxation. He is into Advisory, Litigation and Compliance relating to Direct Taxes, Indirect Taxes, Corporate Law and various Labour Laws in India.

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