The Department for Promotion of Industry and Internal Trade (DPIIT) issued a notification on February 19, 2019 giving a major tax relief to the start-ups which have received funding from Angel investors and has, thus, become an angel for the Indian start-up ecosystem.
Here is a detailed analysis on the issue of Angel Tax:
A) The Income-tax Act, 1961:
As per section 56(2)(viib) of the Income-tax Act, 1961 (“the Act”), when a closely held company receives consideration, for issue of its shares, exceeding the Fair Market Value (“FMV”) of shares, the aggregate amount of consideration as exceeds the FMV of the shares is treated as income and a minimum tax of 26% (including cess) is levied on such income.
For example:
If FMV of shares of XYZ Private Limited is Rs. 100 and it receives an investment of Rs. 1000 against the issue of its shares, XYZ Private Limited shall have to pay income tax of at least 26% on Rs. 900 (1000 less 100).
A lot of start-ups had received a notice from the Income Tax Department proposing an addition under section 56(2)(viib) of the Act. This has resulted in chaos in the start-up industry.
India is in a phase where young, talented and qualified entrepreneurs are givingup the comforts of sitting and working in a plush office under someone and are, instead, ready to sweat it out and work for themselves. Such a start-up ecosystem is crucial for the development of any country as it generates employment, increases Gross Domestic Product and provides revenue to the Government by way of direct and indirect taxes. As per the statistics, 16,202 start-ups have already been recognized by the Government and the number is only going to increase further. However, such a provision and a consequent tax rate of 26% (popularly known as Angel tax) is draconian for a cash-strapped start-up which would have received funding after a lot of efforts. Such a provision will only dampen the start-up sentiment which will be negative for a developing economy like India.
B) DPIIT to the rescue:
In order to avoid hardships faced by the start-ups in India, the DPIIT had come up with a notification in April 2018 which required the start-ups to obtain a certificate from the Inter-Ministerial Board (IMB) by making an online application to avoid Angel tax implications. However, as per statistics, out of 16,022 recognised start-ups, only 94 start-ups have been successful in obtaining such a certificate from the IMB. This is not even 1% of the recognized start-ups.
In this respect, a lot of representations were made to the Government and in response, DPIIT came up with a notification in January 2019 in which the requirement to obtain a certificate from the IMB was done away with and instead, start-ups seeking exemption from Angel Tax were required to make an application the DPIIT which would be then forwarded to the Central Board of Direct Taxes (CBDT) and CBDT shall, then decide whether to grant exemption or not. In effect, the fate of the start-ups in respect of Angel tax was shifted from IMB to CBDT. This too did not go well with the industry and representations were again made to the Government in this regard.
In this response, DPIIT has come up with a notification on February 19, 2019 which requires start-ups to only make a self-declaration in order to claim exemption from Angel Tax. The notification has also brought a lot of other significant changes which have been welcomed by the industry.
C) Decoding DPIIT notification dated February 19, 2019:
Some of the significant changes brought about by the notification are:
1) Amending the definition of a start-up:
a) An entity will be regarded as a start-up for a period of ten (10) years from the date of its incorporation/registration. Earlier, it was seven (7) years.
b) Further, the turnover limit has been increased from Rs. 25 crores to Rs. 100 crores. This effectively means that an eligible start-up can now have a turnover up to Rs. 100 crores.
2) Relaxing Angel tax norms:
a) A start-up having an aggregate amount of share capital and share premium after the proposed issue of shares up to Rs. 25 crores shall not be required to pay tax under section 56(2)(viib) even though the consideration received for issue of shares exceeds FMV of the shares.
b) Further, while computing the maximum limit of Rs. 25 crores, amounts invested by the following shall be not considered:
- A non-resident;
- A Venture Capital Fund (VCF) or a Venture Capital Company (VCC);
- Listed companies whose shares are frequently traded and who have a net-worth of at least Rs. 100 crores or a turnover of at least Rs. 250 crores (specified company).
c) Further, a valuation report from a merchant banker for computing FMV of the shares is no longer required.
d) Let us understand this with an example:
XYZ Private Limited, a recognized start-up received an additional investment of Rs. 100 crores against issue of its shares. The investors were as follows:
- Rs. 10 crores from Mr A, a non-resident;
- Rs. 15 crores from a VCF;
- Rs. 51 crores from a specified company
- Rs. 24 crores from others.
In this case, the aggregate amount of share capital and share premium exceeds Rs. 25 crores. However, investments from Mr. A, VCF and specified company shall not be considered in computing the aggregate amount of share capital and share premium. Since, the amount of investment by others was only Rs. 24 crores (i.e. less than Rs. 25 crores), XYZ Private Limited shall be eligible for exemption from Angel tax.
e) Thus, XYZ Private Limited which would have been otherwise required to pay tax of around Rs. 25 crores, will not be required to pay any tax now. One can imagine the magnitude of relief it has brought about to the start-up industry. Further, any investments from foreign entities in otherwise eligible start-ups shall not attract any tax at all since investments by a non-resident are to be excluded in computing the maximum limit of Rs. 25 crores. Such a provision will increase foreign investments in Indian entities, which is a positive move for an emerging economy like India.
D) Notification whether to apply prospectively or retrospectively?
The Notification states that it shall apply irrespective of the dates on which shares are issued by the start-up from the date of its incorporation. Thus, the notification shall apply retrospectively.
However, the notification further states that it shall not apply to issue of shares in respect of which an addition under section 56(2)(viib) of the Act has been made in the assessment order passed before February 19, 2019.
E) Nothing worth having comes easy:
The latest notification has put to rest most of the issues faced by the start-ups. However, the start-ups are still required to fulfil the following conditions to claim exemption:
1) The start-up has to be recognized by the DPIIT;
2) The start-up must not invest in the following assets for a period of seven (7) years from the end of the latest year in which shares are issued at premium:
a) Building or land appurtenant thereto (except when occupied for its business or when the start-up is in the business of renting or trading of building or land);
b) Loans and advances (except when done in ordinary course of business of lending money);
c) Capital contribution to any other entity or purchase of shares or securities;
d) Motor vehicle, aircraft, yacht or any mode of transport, the actual cost of which exceeds ten lakhs rupees (except when done in ordinary course of business);
e) Jewellery(except when done in ordinary course of business).
Start-ups are required to provide a self-declaration in form 2 in respect of the fulfilment of the above conditions.
3) Such restrictions on investments were necessary to ensure that the funds received by the start-ups are not diverted to other entities by way of investment in such entities. The restrictions will also put a check on investments in real estate, bullion and luxurious vehicles by the start-ups.
F) Issues left unanswered:
The latest notification has not covered the following issues:
1) Assessment order making an addition under section 56(2)(viib) already passed before February 19, 2019:
The notification clearly states that it shall not apply to issue of shares in respect of which an addition under section 56(2)(viib) of the Act has been made in the assessment order passed before February 19, 2019. Thus, in such cases, the pain faced by the start-ups is not over and they will be required to go to the higher appellate authorities to seek relief.
2) Exemption under section 80-IAC still requires approval from the IMB:
The latest notification has provided simplified procedures to claim exemption in respect of income under section 56(2)(viib) of the Act only. Start-ups still have to make an application to the IMB to claim exemption under section 80-IAC of the Act. Similar reliefs and simplified procedures to claim exemption under section 80-IAC of the Act is the need of the hour.
3) Whether actual cost of modes of transport to include Goods and Services Tax (GST) while calculating the upper limit of Rs. 10 lakhs?
Start-ups cannot invest in modes of transport, the actual cost of which exceeds Rs. 10 lakhs. Whether the actual cost is to be computed including or excluding GST is a question left unanswered.
G) Conclusion:
The latest notification has put to rest a lot of issues and hassles faced by the start-up ecosystem in India. This will boost the investments in the start-up industry, which in turn, will boost the Indian economy. The latest notification is also in line with the ‘ease of doing business’ ideology of the Indian government. An appropriate circular from the CBDT is also expected to come soon.
The start-ups must now gear up to get themselves recognized by the DPIIT and file a self-declaration in order to claim exemption. Get in touch with us to get yourself recognized as a start-up.
For those start-ups, which have already received assessment order before February 19, 2019, making an appeal to the higher appellate authorities is the only way out. Appropriate professional advice is required to fight at the appellate stage.
For professional guidance, please do not hesitate to contact your start-up advisor at +91 96991 11783 or at raj.sheth@bhaskara.in.
Disclaimer: This article is for the purpose of general awareness and does not represent professional opinion of the author.
Great article Raj!