Angel Investment Tax on Start-ups
Section 56(2)(viib) of the Income Tax Act levies tax on investments done by any resident person above fair market value(FMV) in any company, as excess amount above FMV is considered as income of the Investee company (Start-up Company).
However, in June 2016, the tax department has issued a notification stating that even if investment in start-up is above FMV, tax on such investments which is above the FMV will be exempt for start-ups.
For the purpose of getting exemption “start-up” shall mean a company in which the public are not substantially interested and which fulfils the conditions specified in the notification1 of the Government of India dated 18th February, 2016.
An entity shall be considered as a ‘start-up’:
1. Up to five years from the date of its incorporation/registration,
(For Instance If registered as a company on 1st January 2012 than it will be eligible to be start-up till 31st December, 2017, though registered as start-up with Government on 31st December, 2016)
(But as per the amendments by the finance Act, 2016 start-up as defined under explanation below sub section 4 of section 80IAC of the Income Tax Act, 1961 should be the one registered or incorporated between 1st April, 2016 to 31st March, 2019 and also the IMB is not giving certificates to start-ups for tax benefits, registered or incorporated before 1st April, 2016. So for tax benefits start-up must be registered or incorporated after 1st April, 2016)
2. If its turnover for any of the year does not exceeds Rs.25 Crore, and
(In above example if turnover of the company for FY 2016-17 is Rs.30 Crore, than it cannot be registered as a start-up under this scheme or if already registered, will cease to be a start-up under this definition)
(As per the amendments by the finance Act, 2016, startup as defined under explanation below sub section 4 of section 80IAC of the Income Tax Act, 1961, the total turnover of its business should not exceed Rs.25 Crore during any financial year from 1st April, 2016 to 31st March, 2021)
3. It is working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property
(Explained Below)
Any such entity formed by splitting up or reconstruction of a business already in existence shall not be considered a 'start-up';
In order to obtain tax benefits a start-up so identified under the above definition should be incorporated or registered after 1/4/2016 and shall be required to obtain a certificate of an eligible business from the Inter-Ministerial board(IMB) of Certification consisting of (additional requirement for tax benefit):
- Joint Secretary, Department of Industrial Policy and Promotion(DIPP),
- Representative of Department of Science and Technology, and
- Representative of Department of Biotechnology.
Points to be considered before registering as a start-up with DIPP and applying for tax benefit certification from IMB:
1. An entity shall cease to be a start-up on completion of five years from the date of its incorporation/registration or if its turnover for any previous year exceeds Rupees 25 crore.
2. Entity means a private limited company or a registered partnership firm or a LLP.
(As per the amendments by the finance Act, 2016, start-up as defined under explanation below
Sub section 4 of section 80IAC of the Income Tax Act, 1961,states that only a company or a LLP is eligible to be a startup under Income Tax Act. So a registered partnership firm cannot claim tax benefits of being a startup and also IMB is not certifying them.
3. Turnover is as defined under the Companies Act, 2013.
4. An entity is considered to be working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property if it aims to develop and commercialize:
a. A new product or service or process, or
b. A significantly improved existing product or service or process that will create or add value for customers or workflow.
Mere act of developing:
a. products or services or processes which do not have potential for commercialization, or
b. undifferentiated products or services or processes, or
c. products or services or processes with no or limited incremental value for customers or workflow would not be covered under this definition.
5. The process of recognition as a 'startup' shall be through mobile app/portal of the department of Industrial Policy and Promotion. Startups will be required to submit a simple application including any of the following documents
a) A recommendation (with regard to innovative nature of business), in a format specified by Department of Industrial Policy and Promotion, from any Incubator established in a postgraduate college in India; or
b) A letter of support by any incubator which is funded (in relation to the project) from Government of India or any State Government as part of any specified scheme to promote innovation; or
c) A recommendation (with regard to innovative nature of business), in a format specified by Department of Industrial Policy and Promotion, from any incubator recognized by Government of India; or
d) A letter of funding of not less than 20 per cent in equity by any Incubation Fund /Angel Fund/Private Equity Fund/Accelerator/Angel Network duly registered with Securities and Exchange Board of India that endorses innovative nature of the business. Department of Industrial Policy and Promotion may include any such fund in a negative list for such reasons as it may deem fit; or
e) A letter of funding by Government of India or any State Government as part of any specified scheme to promote innovation; or
f) A patent filed and published in the Journal by the Indian Patent Office in areas affiliated with the nature of business being promoted.
6. Once such application with relevant document is uploaded a real-time recognition number will be issued to the startup. If on subsequent verification, such recognition is found to be obtained without uploading the document or uploading any other document or a forged document, the concerned applicant shall be liable to a fine which shall be fifty per cent of paid up capital of the startup but shall not be less than Rupees 25,000.
7. This notification shall come into force on the date of its publication in the Official Gazette i.e. 18th February, 2016
Till date around 428 startups have been recognized by the DIPP as per data available on the official website startupindia.gov.in and startups certified for tax benefit purposes by IMB is a small fraction of startups recognized by DIPP.
If your startup does not qualify to be a startup as per above mentioned conditions in the notification then you may fall prey to the draconian rational provisions of section 56(2)(viib) of the Income Tax Act 1961, which is widely known as Angel Investment Tax.
Now let us understand the purpose of bringing this provision in the Income Tax Act
There was a practice of circulating black money by issuing shares at premium, which was tax exempt before this section {(56 (2)(viib)} came into picture.
For example;
Suppose there is a raid in the office of A Ltd and the officers demanded 6 crores as bribe. Now Mr A (director of A Ltd) don’t have such big amount available with him at the moment. He calls up his friend who is in real estate business Mr B. Mr B accepts to provide him Rs. 6 Crores in Cash and on behalf of this asks Mr A to invest in the company of Mr B, B Pvt Ltd, equity shares worth Rs 6 Crores with premium (being 1% of the total equity of the company and the face value or FMV of this shares is Rs.1000). This 1% does not affect Mr B’s interest in that company and the matter gets settled thereon.
To curb this practice which was tax exempt, government came up with the provisions of section 56(2)(viib) which is explained below in this article. Though startups with genuine angel investments at the early stage of their life, may fall prey to section 56(2)(viib). Which may result in outflow of 30% of the value received exceeding the Fair market value of the shares if investment is above Face Value of the share i.e. on premium.
Now let us look at what exactly is taxable under section 56(2)(viib) and how it is rational.
Section 56(2)(viib) : Where a company(Start Up), not being a company in which the public are substantially interested2, receives in any previous year, from any person(Company, individual, LLP, HUF etc) 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 FMV of the shares.
E.g.
a. Mr A (Angel Investor) Invest in XYZ Pvt Ltd Rs 25 Lakhs for 2500 shares @ Rs.1000 per share.
b. Face Value of a share of XYZ Pvt Ltd is Rs.100
c. Mr A invest in the shares of XYZ Pvt Ltd @ Rs.1000 per share i.e. on a premium of Rs.900 per share. This triggers section 56(2)(viib)
d. Suppose the Fair Market Value of a share of XYZ Pvt Ltd is Rs.750/- as determined by any prescribed valuation method or by the assessing officer than XYZ Pvt Ltd will have to pay tax @ applicable to it (29.87% or 32.857% or 30.9% or 33.99%) on Rs. 625,000/- ((1000-750)*2500)
This clause shall not apply
a. where the consideration for issue of shares is received –
(i) by a venture capital undertaking from a venture capital company or a venture capital fund3
(Investment by a Venture capital company or a fund to a Private Limited Company involved in providing services or manufacturing products)
(ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf.
(This gives power to Central Government to issue notification of exempting Angel Investment in eligible startup from tax under section 56(viib) as detailed above)
Classes of Investor are exempt. So if a non venture capital Fund or Company invests in a venture capital undertaking than also section 56(viib) will attract.
b. any such property received by way of a transaction not regarded as transfer under clause (via) or clause (vic) or clause (vicb) or clause (vid) or clause (vii) of section 47 of the Income tax Act, 1961.
(i.e. amalgamation, demerger, business regorganisation of a cooperative bank, transfer of share in demerger, transfer of shares in amalgamation)
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
(Methods are prescribed in sub rule 2 of rule 11UA of the Income Tax Rules where the assessee has an option to adopt any one of the two methods mentioned in the sub rule:
1. Book Value with some adjustments or
2. valuation by a Chartered Accountant, not being the statutory or tax auditor of the Company or by a Merchant Banker using Discounted Free Cash Flow Method(DCFC).) 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, Knowhow, Patents, Copy rights, Trademarks, Licenses, Franchises, or any other business or commercial rights of similar nature.
whichever is higher
Points to be considered
1. FMV as per valuation method of “Book Value with some adjustments” and FMV as may be substantiated by the company to the satisfaction of the Assessing Officer would be much lesser than the amount investment brought in by the Angel Investor. So company should get a valuation report by a CA or Merchant Banker based on DFCF Method before taking in investment from an angel investor.
2. But still the AO may reject the valuation and invoke section 56(2)(viib), since valuation as per DFCF is also a result of an estimation and rationally AO might not accept the estimation based on the performance of the company in future years after receiving the angel investment, since the year in which the investment is received will be scrutinized after 1 or 2 years from the date of the investment.
3. Documentary evidences and explanations should be kept for estimations done.
4. Instead of issuing equity shares the company may issue compulsorily convertible debentures to be converted into equity on a future date based on a predetermined method. The method can differ from case to case, based on the negotiations of the transacting parties. Conversion of Debentures into Equity shares is not regarded as transfer as per the Income Tax Act, 1961 hence no capital gain will be attracted on this conversion.
1. Government of India, Ministry of Commerce and Industry, Department of Industrial Policy and Promotion, Number G.S.R.I 80(E), dated the 17th February, 2016, published in the Gazette of India, Extraordinary, Part II, section 3, sub section (i), dated the 18th February, 2016
2. Section 2(18) in The Income- Tax Act, 1995
(18) " company in which the public are substantially interested" -- a company is said to be a company in which the public are substantially interested--
(a) 2 if it is a company owned by the Government or the Reserve Bank of India or in which not less than forty per cent of the shares are held (whether singly or taken together) by the Government or the Reserve Bank of India or a corporation owned by that bank; or]
(aa) 3 if it is a company which is registered under section 25 of the Companies Act, 19564 (1 of 1956 ); or
(ab) if it is a company having no share capital and if, having regard to its objects, the nature and composition of its membership and other relevant considerations, it is declared by order of the Board to be a company in which the public are substantially interested: Provided that such company shall be deemed to be a company in which the public are substantially interested only for such assessment year or assessment years (whether commencing before the 1st day of April, 1971 , or on or after that date) as may be specified in the declaration; or]
(ac) 5 if it is a mutual benefit finance company, that is to say, a company which carries on, as its principal business, the business of acceptance of deposits from its members and which is declared by the Central Government under section 620A of the Companies Act, 19566 (1 of 1956 ), to be a Nidhi or Mutual Benefit Society; or]
(ad) 7 if it is a company, wherein shares (not being shares entitled to a fixed rate of dividend whether with or without a further right to participate in profits) carrying not less than fifty per cent of the voting power have been allotted unconditionally to, or acquired unconditionally by, and were throughout the relevant previous year beneficially held by, one or more co- operative societies;]
(b) 8 if it is a company which is not a private company as defined in the Companies Act, 19569 (1 of 1956 ), and the conditions specified either in item (A) or in item (B) are fulfilled, namely:-
(A) shares in the company (not being shares entitled to a fixed rate of dividend whether with or without a further right to participate in profits) were, as on the last day of the relevant previous year, listed in a recognized stock exchange in India in accordance with the Securities Contracts (Regulation) Act, 1956 1 (42 of 1956 ), and any rules made there under;
(B) 2 shares in the company (not being shares entitled to a fixed rate of dividend whether with or without a further right to participate in profits) carrying not less than fifty per cent of the voting power have been allotted unconditionally to, or acquired unconditionally by, and were throughout the relevant previous year beneficially held by-
(a) the Government, or
(b) a corporation established by a Central, State or Provincial Act, or
(c) any company to which this clause applies or any subsidiary company of such company 1 if the whole of the share capital of such subsidiary company has been held by the parent company or by its nominees throughout the previous year.] Explanation.- In its application to an Indian company whose business consists mainly in the construction of ships or in the manufacture or processing of goods or in mining or in the generation or distribution of electricity or any other form of power, item (B) shall have effect as if for the words" not less than fifty per cent", the words" not less than forty per cent" had been substituted;]]
3(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 1 to clause (23FB) of section 10.
The author can also be reached at ajsomani@gmail.com
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