Angel Tax demystified
Angel Tax in India — Demystified and Explained
Section 56(2)(viib) of the Income Tax Act, 1961, or the dreaded “Angel Tax” was inserted by the Finance Act, 2012 to tax any capital raised by a closely held company which is above its Fair Market Value (FMV) as income from other sources, with Rule 11UA(2) stipulating the following two methods for determining the Fair Market Value:
· Net Asset Value (NAV) Method
· Discounted Free Cashflow (DCF) Method
However, the Fair Market Value in section 56(2)(viib) is defined as the value
(i) as may be determined in accordance with such method as may be prescribed (Rule 11UA(2));
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;
This section, in particular, has been a bane to small businesses, startups, and investors as it seeks to tax any amounts invested by a resident individual into a privately held company. In the sections below, we will explore the problems with the sections that govern the Angel Tax issue as well as the remedies that have been actioned by the government.
With a few more recommended clarifications and modifications, the entire issue can be resolved to incentivise the ecosystem and reward good behaviour.
Analysis of Section 56(2)(viib)
The reason why 56(2)(viib) evokes such fear in the hearts of startups and investors is that it bestows significant discretionary powers in the hands of the Assessing Officer (AO), goes against the principles of the DCF method, and until recently, discriminated against individuals on the basis of residency.
There are four major issues with this section which causes significant problems to Indian startups.
1. Lack of Enforcement of the Law:
56(2)(viib) clearly states that the FMV shall be the higher of:
— Value as per NAV or DCF (Rule 11UA(2))
OR
— Value to the satisfaction of the AO based on the value of the company as of the date of issue of shares
From a plain reading of the section, it can evident that even if the AO is unsatisfied about the value of the Company or believes the value to be lower, the disjunctive OR allows for the higher value to be the Fair Market Value (FMV).
Ideally, the Assessing Officer should not have the discretionary power to disregard a valuation acceptable to the entrepreneurs and a group of sophisticated investors and arrived at by a professional in the form of a qualified Chartered Accountant or a Category I Merchant Banker. Many startups have faced a challenge whereby the AO takes the lower value as the FMV and taxes the entire premium as income in the hands of the companies. This results in the law not being fully enforced, leading to consistent bias against the companies.
2. Discretionary powers of the IT Officer:
The valuation arrived at by the Company is on the basis of a Valuation Report given by a qualified Chartered Accountant or Category I Merchant Banker, is based on the inputs of the management and is acceptable to sophisticated investors. However, it has the additional criterion of being to the satisfaction of the Assessing Officer. This subjective interpretation often goes against the objective valuation methodologies specified in the Income Tax Act.
For tech entrepreneurs or ventures with long gestation cycles, this hampers the flow of invaluable capital needed to scale their businesses and causes a lot of them to flee to other countries like Singapore or the United States of America to escape this requirement to satisfy the AO.
This imputes significant discretionary powers in the hands of the IT Officers and exposes startups to the tender mercies of the taxman. It also takes away from the very basic tenets of finance, as shown below.
3. Projections vs Perfection
The principle of a DCF valuation is to encapsulate the present value of possible future cash flows. These are based upon a Business Plan prepared by the entrepreneur to the best of their abilities, and subject to various risk factors, market conditions, etc.
To penalise an entrepreneur for failing to exactly reach their projections by comparing it to their financials on a later date vitiates against the very premise of DCF and robs of the uncertainty inherent in it.
The market penalises failure by making future funding harder to come by, an erosion of brand value, of morale, etc. — but adding the risk of a massive tax liability for assuming that the future is certain will cripple the entrepreneurial mindset of venturing forth in spite of deviations from ideal plans.
The law states that the FMV is based on the valuation methodology adopted as of today, but takes into consideration what the future may hold. However, 56(2)(viib)(ii) flips this on its very head, as shown below.
4. Present Tense, Future Uncertain
56(2)(viib)(ii) states that the Company needs to satisfy the Assessing Officer based on the value of the Company as of the date of the fundraise, whereas the valuation methodologies (56(2)(viib)(i), which leads to Rule 11UAA), allow for you to discount future cash flows as of today.
These contradict each other as the value as of today will always be less than the value in the future.
This allows for the complete disregard of the DCF methodology by the AO, leading to taxation on the basis of the present Net Asset Value instead of the probable future value.
The Added Dread of Section 68
In addition to the challenges with 56(2)(viib), Section 68 of the Income Tax Act, 1961 adds another dimension to these issues. Section 68 states that any sum credited to the books of accounts of an assessee can be charged to tax if:
The assessee is unable to explain the source of the credit;
OR
The explanation is not to the satisfaction of the Assessing Officer
Several startups, who have faced off with the sword of section 56(2)(viib), also have to contend with section 68, which again allows for significant discretionary powers in the hands of the Assessing Officer compounded by the discretionary powers already afforded by section 56(2)(viib).
This tag-team reminds one of the chants that haunted the English cricket team during the 1974–75 Ashes tour of Australia-
Ashes to Ashes, dust to dust,
if Thomson don’t get ya, Lillee must.
Given a choice, several entrepreneurs would rather brave the danger of th speedsters than the discretion of the taxman.
Remedies Already Enforced
The government has taken several proactive steps to protect and nurture the startup ecosystem in India. But this Sword of Damocles still dangles over the head of every entrepreneur. Until it is sheathed for good, there will always be fear about these issues.
On June 14th, 2016, the CBDT released a notification stating that for any company registered as a “Startup” and recognised by the Department of Industrial Policy & Planning (DIPP), any amount raised from an Indian tax resident will be outside the scope of section 56(2)(viib). The total list of exemptions to this section are:
Any funds received from a Venture Capital Fund or Venture Capital Company
Any class of people as notified by the Central Government, such as:
— Non-residents
— From June 14th, 2016 — for a company registered as a “startup” under the Startup India Scheme — any resident
While this goes a long way in helping future companies, those who raised money in assessment years 2015–16 and prior are still exposed to this section even if they are startups.
Recommendations
With a few more additions and clarifications to these sections, the last vestiges of doubt can be quickly addressed to help the startup ecosystem proceed forward with clarity and confidence.
If a company has a valid valuation report in accordance with the law, the tax authorities should not be able to question if the valuation is justified based on prospective information
If any entity qualified to be a startup from June 14th, 2016 onwards, 56(2)(viib) should not apply for any funds raised at a premium from the date of their incorporation
The exemption under 56(2)(viib) offered to a startup shouldn’t be denied on the technical failure of not applying to become a startup if they qualified to become recognised
The PAN details of the Investors should be sufficient explanation of the nature of the cash credit for Section 68 and for the Assessing Officer to decide, based on the investors past tax filings, if the source of income can be substantiated or not
Conclusion
Out of the USD 10 Billion of investment into the Indian startup ecosystem last year, only 10% of it came from domestic investors. If the inspirational Make in India and Startup India visions of the government are to be achieved and the true value of the ecosystem is to be unlocked, the government must focus on encouraging domestic investment instead of penalising it. Domestic investors shouldn’t be discriminated against and treated sub-par to foreign investors in terms of the legitimacy of their money, which is the current status quo under 56(2)(viib).
After all, a tax is not the best form of defence. more
Section 56(2)(viib) of the Income Tax Act, 1961, or the dreaded “Angel Tax” was inserted by the Finance Act, 2012 to tax any capital raised by a closely held company which is above its Fair Market Value (FMV) as income from other sources, with Rule 11UA(2) stipulating the following two methods for determining the Fair Market Value:
· Net Asset Value (NAV) Method
· Discounted Free Cashflow (DCF) Method
However, the Fair Market Value in section 56(2)(viib) is defined as the value
(i) as may be determined in accordance with such method as may be prescribed (Rule 11UA(2));
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;
This section, in particular, has been a bane to small businesses, startups, and investors as it seeks to tax any amounts invested by a resident individual into a privately held company. In the sections below, we will explore the problems with the sections that govern the Angel Tax issue as well as the remedies that have been actioned by the government.
With a few more recommended clarifications and modifications, the entire issue can be resolved to incentivise the ecosystem and reward good behaviour.
Analysis of Section 56(2)(viib)
The reason why 56(2)(viib) evokes such fear in the hearts of startups and investors is that it bestows significant discretionary powers in the hands of the Assessing Officer (AO), goes against the principles of the DCF method, and until recently, discriminated against individuals on the basis of residency.
There are four major issues with this section which causes significant problems to Indian startups.
1. Lack of Enforcement of the Law:
56(2)(viib) clearly states that the FMV shall be the higher of:
— Value as per NAV or DCF (Rule 11UA(2))
OR
— Value to the satisfaction of the AO based on the value of the company as of the date of issue of shares
From a plain reading of the section, it can evident that even if the AO is unsatisfied about the value of the Company or believes the value to be lower, the disjunctive OR allows for the higher value to be the Fair Market Value (FMV).
Ideally, the Assessing Officer should not have the discretionary power to disregard a valuation acceptable to the entrepreneurs and a group of sophisticated investors and arrived at by a professional in the form of a qualified Chartered Accountant or a Category I Merchant Banker. Many startups have faced a challenge whereby the AO takes the lower value as the FMV and taxes the entire premium as income in the hands of the companies. This results in the law not being fully enforced, leading to consistent bias against the companies.
2. Discretionary powers of the IT Officer:
The valuation arrived at by the Company is on the basis of a Valuation Report given by a qualified Chartered Accountant or Category I Merchant Banker, is based on the inputs of the management and is acceptable to sophisticated investors. However, it has the additional criterion of being to the satisfaction of the Assessing Officer. This subjective interpretation often goes against the objective valuation methodologies specified in the Income Tax Act.
For tech entrepreneurs or ventures with long gestation cycles, this hampers the flow of invaluable capital needed to scale their businesses and causes a lot of them to flee to other countries like Singapore or the United States of America to escape this requirement to satisfy the AO.
This imputes significant discretionary powers in the hands of the IT Officers and exposes startups to the tender mercies of the taxman. It also takes away from the very basic tenets of finance, as shown below.
3. Projections vs Perfection
The principle of a DCF valuation is to encapsulate the present value of possible future cash flows. These are based upon a Business Plan prepared by the entrepreneur to the best of their abilities, and subject to various risk factors, market conditions, etc.
To penalise an entrepreneur for failing to exactly reach their projections by comparing it to their financials on a later date vitiates against the very premise of DCF and robs of the uncertainty inherent in it.
The market penalises failure by making future funding harder to come by, an erosion of brand value, of morale, etc. — but adding the risk of a massive tax liability for assuming that the future is certain will cripple the entrepreneurial mindset of venturing forth in spite of deviations from ideal plans.
The law states that the FMV is based on the valuation methodology adopted as of today, but takes into consideration what the future may hold. However, 56(2)(viib)(ii) flips this on its very head, as shown below.
4. Present Tense, Future Uncertain
56(2)(viib)(ii) states that the Company needs to satisfy the Assessing Officer based on the value of the Company as of the date of the fundraise, whereas the valuation methodologies (56(2)(viib)(i), which leads to Rule 11UAA), allow for you to discount future cash flows as of today.
These contradict each other as the value as of today will always be less than the value in the future.
This allows for the complete disregard of the DCF methodology by the AO, leading to taxation on the basis of the present Net Asset Value instead of the probable future value.
The Added Dread of Section 68
In addition to the challenges with 56(2)(viib), Section 68 of the Income Tax Act, 1961 adds another dimension to these issues. Section 68 states that any sum credited to the books of accounts of an assessee can be charged to tax if:
The assessee is unable to explain the source of the credit;
OR
The explanation is not to the satisfaction of the Assessing Officer
Several startups, who have faced off with the sword of section 56(2)(viib), also have to contend with section 68, which again allows for significant discretionary powers in the hands of the Assessing Officer compounded by the discretionary powers already afforded by section 56(2)(viib).
This tag-team reminds one of the chants that haunted the English cricket team during the 1974–75 Ashes tour of Australia-
Ashes to Ashes, dust to dust,
if Thomson don’t get ya, Lillee must.
Given a choice, several entrepreneurs would rather brave the danger of th speedsters than the discretion of the taxman.
Remedies Already Enforced
The government has taken several proactive steps to protect and nurture the startup ecosystem in India. But this Sword of Damocles still dangles over the head of every entrepreneur. Until it is sheathed for good, there will always be fear about these issues.
On June 14th, 2016, the CBDT released a notification stating that for any company registered as a “Startup” and recognised by the Department of Industrial Policy & Planning (DIPP), any amount raised from an Indian tax resident will be outside the scope of section 56(2)(viib). The total list of exemptions to this section are:
Any funds received from a Venture Capital Fund or Venture Capital Company
Any class of people as notified by the Central Government, such as:
— Non-residents
— From June 14th, 2016 — for a company registered as a “startup” under the Startup India Scheme — any resident
While this goes a long way in helping future companies, those who raised money in assessment years 2015–16 and prior are still exposed to this section even if they are startups.
Recommendations
With a few more additions and clarifications to these sections, the last vestiges of doubt can be quickly addressed to help the startup ecosystem proceed forward with clarity and confidence.
If a company has a valid valuation report in accordance with the law, the tax authorities should not be able to question if the valuation is justified based on prospective information
If any entity qualified to be a startup from June 14th, 2016 onwards, 56(2)(viib) should not apply for any funds raised at a premium from the date of their incorporation
The exemption under 56(2)(viib) offered to a startup shouldn’t be denied on the technical failure of not applying to become a startup if they qualified to become recognised
The PAN details of the Investors should be sufficient explanation of the nature of the cash credit for Section 68 and for the Assessing Officer to decide, based on the investors past tax filings, if the source of income can be substantiated or not
Conclusion
Out of the USD 10 Billion of investment into the Indian startup ecosystem last year, only 10% of it came from domestic investors. If the inspirational Make in India and Startup India visions of the government are to be achieved and the true value of the ecosystem is to be unlocked, the government must focus on encouraging domestic investment instead of penalising it. Domestic investors shouldn’t be discriminated against and treated sub-par to foreign investors in terms of the legitimacy of their money, which is the current status quo under 56(2)(viib).
After all, a tax is not the best form of defence. more
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