Co-Author: Adv. Sarthak Shetty

With the intention to promote small businesses and entrepreneurship in India, the current government introduced several measures such as easier registration requirements, subsidies, tax rebate of 100% of profits to ‘eligible’ start-ups for a period of three out of the first seven years, etc. This also gave fillip to small businesses promising to be innovative, such as in the field of e-commerce, technological innovations, consumer services, etc. Albeit the tax benefit is restricted to those who fulfil certain criteria and receive a certificate from the Inter-Ministerial Board. A large number of start-up businesses do not fulfil conditions for registration and hence do not benefit from this exemption.

While there is clear and stated intention to promote new and innovative business ideas, some recent developments seem to run counter to this.  In this article, the authors discuss these aspects.

There is a provision in the Income Tax Act, 1961 (“IT Act”), which was introduced to penalise creation and flow of black money without paying legitimate taxes as well as creating structures to avoid taxes. This provision is known as ‘angel tax’, which seeks to tax a company receiving premium, where such premium is higher than is justifiable by valuation of its shares. The valuation method for this purpose is also prescribed. Originally it was provided that eligible start-ups, which were approved by the Inter-Ministerial Board, could get exemption from this tax subject to fulfilment of certain conditions such as: (a) its share capital and share premium should not exceed INR 10 crores; (b) investor having either (i) average returned income of INR 25 lakhs or more for preceding 3 years; or (ii) net worth of INR 2 crores or more as on the last date of the preceding financial year. Additionally, they were also required to provide a valuation report issued by a merchant banker. However, responding to many representations made in respect of harshness of these provisions which kill the start-ups, on 16 January 2019, the Department of Industrial Policy and Promotion (“DIPP”) issued a notification amending the exemption related conditions. As per this notification, a start-up is no longer required to approach inter-ministerial committee. Instead, it is required to apply to DIPP in the prescribed form submitting the prescribed documentation. The DIPP will transmit the application to the CBDT. The CBDT will be required to communicate its decision to either grant or reject the approval within 45 days of receiving the application from the DIPP. The revised conditions for a start up to be eligible to apply for approval and be exempt from angel tax provisions are: (a) its share capital and share premium should not exceed INR 10 crores; (b) investor should have  (i) returned income of INR 50 lakhs or more for the financial year preceding the year of proposed investment; and (ii) net worth exceeding INR 2 crores or the amount of investment whichever is higher as on the last date of the preceding financial year. No valuation report is required. While the application form for seeking approval has been simplified, the conditions for granting the approval have been made stricter.  Fundamentally, the authors believe that this provision is flawed- even as amended – and needs to be completely reworked.

It is a well-known fact that in case of technological and innovative companies, using innovative business models, or even some traditional businesses using innovative models, the valuations are determined not on the basis of traditional valuation norms but by the potential that the investor perceives in such business and the model. As a result, there are investors who are willing to risk their capital to fund such businesses. Very possibly, in the short run, the business does not take off and loses money but the investors could still see potential and would invest at a high value. This very phenomenon goes against the provision of the IT Act when the investment is made by a resident. The company receiving the investment at high value is treated as having earned income and taxed at the highest rate!

A two pronged approach is being adopted by the authorities where on one hand the tax authorities investigate (a) the identity and creditworthiness of investors and genuineness of the transaction; and (b) whether the valuation and mechanism used to arrive at the said valuation is justified.

What is worth noting is that, tax is levied at the rate of 60% when the company receiving the amounts cannot demonstrate the creditworthiness and identity of the investors and genuineness of the transaction or at the rate of 30% when the share premium amount is unjustifiably high. This is a very high cost for genuine companies when the company would indeed be using the funds for the growth of the business genuinely.

Admittedly the intention of these provisions was to check the facilitation of creation and flow of black money and penalise offenders with a heavy tax levy. However, with all due respect, it must be stated that these provisions are not only harsh and misplaced, they are discriminatory and run contrary to promoting entrepreneurship in the country. The fallacy of implementing these provisions is that, the entity being penalised is the recipient of such amounts rather than the owner and creator of the unaccounted funds! The recipient company in fact is instrumental in bringing the money into the formal economy! Thus, the wrong person/ entity is being penalised and negative impact is created.

It is no one’s case that the wrong doers should not be penalised. However, it is important to frame and implement provisions which achieve this objective effectively without hurting the growth of business.

Unless the company receiving the share capital is established as a sham entity or as an extension of the shareholder, such company should not be subjected to this tax. What is also interesting is that the investee company is discriminated in application of this provision since if the investment was infused by a non-resident, the provision is not attracted. This seems fallacious! With introduction of several new norms to track unaccounted money such as the know your client (KYC) provisions, investments required to be made through banking channels, agreements between parties to necessarily quote the permanent account numbers, the new significant beneficial ownership provisions under the Companies Act, 2013 et al, it is submitted that there is sufficient trail of the flow of funds into these new start-up companies – whether at value higher than or equal to prescribed fair market value.  In view of this, it should be possible to seek the genuineness and authenticity of the funds from the investor itself rather than penalise the recipient of investment. If the investor is unable to establish its credentials, it is fair to levy penal taxes on such person who in the first place is the cause for the unaccounted funds. The government would do well in formulating such provisions to catch defaulters rather than hamper the growth of the small businesses. Share capital is, by definition, a capital receipt which should not be subjected to tax.

All in all, the upcoming budget should relook at these provisions, and rejig the tax norms to achieve what they set out to do. As a matter of principle, it is the offender who should be penalised and not the innocent. If a person is making abnormally large investments which is not justifiable in light of the financial background / strength of the individual then, such person should be paying the penalty for the unaccounted money. This burden should not be cast upon companies, looking to do legitimate businesses and survive in an unpredictable economy. Let us not kill the growth engines of the economy for penalising the wrong doers!

Daksha Baxi, Head International Taxation and Surajkumar Shetty, Principal Associate, Tax Team, Cyril Amarchand Mangaldas, Mumbai

The views expressed in this article are personal views of the authors. The Firm is in no way liable for any of the statements nor does it subscribe to them. This is not meant to be a legal view / advice and no responsibility can be taken by the Firm or the authors for anything contained in this article.