The policy initiatives taken by the DPIIT need to be also backed up by startup friendly tax administration by the CBDT to ensure that the startups survive and thrive in difficult economic conditions
Startups by nature are innovative and full of enthusiasm to break new ground. They need funding, guidance and nurturing. Since the announcement of the Startup India policy in 2016, the Government, through the medium of DPIIT and CBDT, has displayed a lot of enthusiasm to ensure a conducive environment for startups. However, three years later, startups have not been able to reap the benefits of such pro-activism.
Like every other business, startups need someone to put faith in them and to fund them. Similar to other business, what seems to be a bonanza in terms of good valuation ensuring generous funding, could end up invoking the applicability of "Angel Tax" under Section 56(2) (viib) of the Income Tax Act, 1961. The said section seeks to tax the excess consideration for issue of shares received from a resident investor in the hands of the company. Any value received in excess of the fair market value of shares is treated as income in the hands of the startup. The plethora of notifications, at times changing the definition of startup, at times imposing various eligibility conditions on the startup, suggest that obtaining funding is easier than convincing the taxman about the genuineness of such funding.
Section 56 (2) (viib) was originally enacted to curb the practice of black money being routed through closely held companies in the garb of share subscription money. The element of anti-abuse is further fortified by Section 68 which empowers an assessing officer to satisfy himself as regards the source of funds, failing which the share subscription can get taxed in the hands of the company as an unexplained cash credit. These tax provisions had exposed even genuine startups to tax demands on the funding received from investors and had dampened the spirits of these startups.
After a series of representations by the industry, the DPIIT issued a new notification on 19-2-2019 prescribing a new set of conditions to qualify as a startup eligible for relief from application of Section 56 (2) (viib). These include an upper threshold of paid up capital and share premium of the startup being '25 crores, curbs on investments by startup in certain assets like land and building, giving loans and advances as also turnover or earnings criteria for the (resident) investor.
Though the latest DPIIT notification was generally welcomed by the startup community, it did continue to pose a few challenges to them. For instance, some of the conditions prescribed in the notification, especially those relating to restrictions on investments by startups, seem to suggest that the startups have to comply with them not only on the date of application and thereafter, but they must have complied with such conditions even in the past, i.e. right from the company's incorporation. Moreover, some of the restrictions on investments by startups appeared to be sweeping and could have curtailed their normal business operations.
It was always felt that the focus must shift from the startups to the investors, who are investing money in such startups. It was quite unreasonable to cast a heavy burden on the startups to vouch for the genuineness/creditworthiness of the investors. In this background, we now hear that the DPIIT is discussing with CBDT about the concept of "accredited investors". In other economies like US, Singapore etc., the concept of accredited investor is prevalent and is usually based on the economic strength of the investor in terms of assets owned or income earned.
Even today, investments received from certain categories of investors, filling certain net-worth or turnover criteria, are exempt from the applicability of Angel Tax.
On the flip side, one could argue that this scheme of accredited investors may effectively restrain small and genuine investors from buying a stake in promising startups. However, considering that the major portion of investment in startups is likely to come from relatively large investors, the accredited investor scheme may considerably reduce the potential tax exposure currently faced by the startups.
Good intent must get translated into action
While the actions taken by DPIIT do suggest some level of eagerness to find a solution to the problems faced by the startups, the success of these measures will largely depend on how the CBDT transforms all the good intent into action. Our experience till now indicates that the CBDT continues to be primarily focused on augmenting revenue collection and plugging of leakages.
During the course of the last couple of years, startups have continued to be slapped with notices from the department, seeking to tax the share premium, seeking explanation of the source of funds etc., and in some cases, adverse assessments have already been completed. The series of notifications/circulars issued by the CBDT neither provide any tangible relief in respect of completed assessments, nor do they provide assurance that genuine cases of good valuation would be spared. Also, the applicability of Section 68, which empowers the tax officer to inquire into the source of share premium, verify the investor's creditworthiness etc., is untouched by any of these notifications/circulars. Hence, even if a startup is not taxed as per Section 56 (2) (viib), it could still face questions as to the source of share premium under Section 68. Moreover, the burden of proving the genuineness, creditworthiness etc., under Section 68 is still on the startup.
Thus, the policy initiatives taken by the DPIIT need to be also backed up by startup friendly tax administration by the CBDT to ensure that the startups survive and thrive in these difficult economic conditions.
Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.
Partner, Lakshmikumaran & Sridharan Attorneys
Principal Associate, Lakshmikumaran & Sridharan Attorneys