ANGEL TAX · 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

ANGEL TAX

BACKDROP AND

COMPREHENSIVE A N A L Y S I S

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.

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

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

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

YourStory.com

ANGEL TAXTAXMANTRA ANALYSIS

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.


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.


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 long-

term capital asset, being an equity share in a company’. That is how,

Mr. Y converts Rs. 494/- from black to white.


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


CHALLENGES FACED BY THE

GOVERNMENT

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.


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) 2013-14, introduced section 56 (2) (viib), which is now

also termed as ‘Angel Tax’.



WHAT DOES THE LAW SAY

SECTION 56 (2) (Viib)

Section 56 (2) (viib)

Clause (viib) of sub section (2) of section 56 was inserted

vide finance act, 2013 w.e.f 01.04.2013 i.e. for A. Y. 2013-14

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:



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;



(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.



PROBLEMS FACED BY STARTUPS

AND ANGEL INVESTORS

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

which the tax is to be levied.


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


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.



MEASURES ALREADY TAKEN BY

GOVERNMENT

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 2016

8. Public procurement in all central government ministries’

departments


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

605.7 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.


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-

2018 is presented below:


Amendment in the Union Budget 2018


Present Scenario Proposed Changes in Budget-2018

(i) In order to avail the benefits of section

80-IAC, the start-up should have been

incorporated on or after 1st April 2016

and before 1st April 2019.

The benefits has been extended to the

start-ups incorporated even after 1st April

2019 and before 1st April 2021.

(ii) The turnover of the business should

not have exceeded Rs 25 crore rupees in

any of the previous years from 1st April,

2016 to 31st March, 2021.

The requirement of turnover of Rs 25

crore rupees has been applied to seven

previous years commencing from the

date of incorporation.

(iii) The word eligible business includes

innovation, development, deployment or

commercialization of new products,

processes or services driven by

technology or intellectual property.

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 1st 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 1st April 2019. 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’

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.


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.



TAXMANTRA’S TAKE AND THE

WAY FORWARD

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.


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 non-

viable for angel investors to get this registrations.


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.


Taxmantra is a global legal, taxation, compliance and

due-diligence firm with presence in India, Singapore, US

and Middle East.

Since inception in 1983, 40K+ customers have hired

Taxmantra Global as a trusted partner to manage their

compliance, due-diligence, fund raising, taxation and

corporate law.

Several startups, technology companies and SMEs

trust Taxmantra as their Cloud CFO.

• $100M funding assisted

• 300K+ compliances filed

• 3 decades of experience

• Trusted by startups, new

age tech businesses and

investors

TAXMANTRA GLOBALINTRODUCTION/ ABOUT

TAXMANTRA SERVICES

BUSINESS STAGE: EARLY/ STARTING UP

Entity Formation

Local State Specific Compliances, Taxation & Registration

Corporate Law (agreements)

ESOPs Structuring

Trademarks, Patents Filing & Copyrights

Cloud CFO

BUSINESS STAGE: GROWTH STAGE

Taxation

Corporate Law (Litigation Assistance)

Regulatory Compliances

Due-Diligence/ Fund-Raise Assistance

ESOPs Structuring

Cloud CFO

BUSINESS STAGE: MATURE

Taxation

Corporate Law (Litigation Assistance)

Regulatory Compliances

Due-Diligence/ Fund-Raise Assistance

IPO Readiness & Listing On SME Exchange

Cloud CFO

TAXMANTRA ADVANTAGE

DIALOGUE

TAD is a thought leadership platform established by

Taxmantra to share global best practices and unlock more

growth opportunities for Taxmantra customers globally.

We host highly focused workshops and conferences that

share highly valuable content for business owners/

entrepreneurs.

TAD features global speakers on various subjects

pertaining to taxation and law for startups, new age

businesses and technology companies.

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 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.

RAHUL AGARWALLA

VP Operations- India

(South) Taxmantra Global

LEADERSHIP TEAM

Kenneth Ho

VP Operations

TaxMantra Global

(Singapore)

CA RK Patnia

Non Executive Chairman

Taxmantra Global

Kenneth Ho currently serves as VP

Operations (Singapore) as Taxmantra

Global. Kenneth is a professional

trained Accountant with more than

10 years of experience gained from

his employment with 2 mid-tier

international accounting firms and 2

global outsourcing firms. Not limiting

his exposure to accounting

compliance, his experience includes

corporate secretarial compliance,

personal & corporate tax compliance,

Goods & Services Tax (GST)

compliance & payroll compliance

services too.

CA RK Patnia serves as non-

executive chairman at Taxmantra

Global. He is the past president of

Income Tax Bar Association and also

past chairman of The Institute of

Chartered Accountants of India

(ICAI).

He has vast experience in the field of

tax and advisory and known for his

technical expertise in the handling of

income tax search and raid

assessment especially, in active

practice since the year 1983.

LEADERSHIP TEAM

Paritosh serves as the Consulting

VP, Growth & Strategy with

Taxmantra Global.

Paritosh is a leader in brand,,

marketing and business

communication. He has helped

SMEs globally engage powerfully

with new media.

He is also the author of world's first

business book on Patanjali.

PARITOSH SHARMA

Consulting VP - Growth

Taxmantra Global

+91 983603903

fb . com/taxmantra

@taxmantra

www.taxmantra.com

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Documents

ANGEL TAX · 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