Angel Tax Chaos Among Start-ups All that start-ups should know to deal with tax notices

With a view to foster economic development and creation of more employment, the government started a movement of start-ups. This was to get innovative ideas to the platform and get the funding from government or from other angel investors network, to make more first generation entrepreneurs. Tax sops were also announced with a process to attract talent to move to this direction. Any new move normally gets hassled somewhere in the compliances which are called Angel tax and is widely covered in media as it is considered a big blow to start-ups movement.

The new regime has been promoting Innovation and entrepreneurship under the start-up mission as these new age companies have the potential to create jobs. These start-ups are avenues for Angel investors to take them forward. Angel investment normally comes on premium valuation which is based on futuristic earnings base. Angel tax is a tax applied as per section 56(2) of Income Tax act 1961, which is the difference of premium as considered higher than the fair value of shares. Tax officer always sees the valuation on which Angel investors invest as higher than the fair market value and thereby issues show cause notice to put a tax on the said excess value. This tax as such is referred to as Angel tax. This section applies to only unlisted company shares which are not widely held.

Income Tax Notices

Almost all start-ups get funding of the first stage through angel investors in their first year of working. Their net operating results in that year are normally operational loss as the invested amount is put to technology or in the payroll of people working as such. Hence when they file their tax returns, these returns show a Loss from business operations. While the infusion of capital is shown at the premium. Therefore, in random check analysis, this premium led share capital iOS considered as abnormal and tax scrutiny notices are sent to the start-ups to explain the basis of valuation with the valuation report, to come clean. This section of 56(2) is draconian and it is used sometimes to harass start-ups, which are always starved for liquidity and funds.

Impact of Angel Tax on Investments

Such tax notices will definitively impact start-up activities including investments in these start-ups. The government had earlier eased the tax provision by building safeguards, although it could not ease the pain of start-ups. Since start-ups are valued based on the business potential of their ideas, which could change with the time, sometimes it's difficult and hard to justify the share premium received. In view of the fact that ratio of successful start-up is very low , could be below five in 100 start-ups , these notices become pain overall and angel investors, therefore, shy away to promote bright ideas and would prefer to invest in phase two when the initial funding is already there and the project is showing its shape . At the same time good projects will still mushroom and over the next couple of years, once this tax provision will settle down, the negative impact on fresh investment will die down.

How Should Start-ups Deal With Such Tax Notices?

Start-ups need to know the valuation process which is acceptable to tax authorities. Now an approved valuer including a merchant banker only can make a value which they need to authenticate based on their specialized skill set. Such a certificate will help start-ups to satisfy the assessing authorities on the genuineness of the transaction.

The Government's Stand

In view of notices issued in these provisions in large-scale, the government also feel that it is creating a negative impact, which was not the intent in introducing this section when it was done in 2012. Hence government issued a clarification that no coercive action till expert panel resolves this issue. The issue of shares at a premium is a common practice in new age enterprises. Central board of direct taxes (CBDT) has mentioned that they recognize that start-ups are going to bring a lot of innovation to the country and therefore have to be supported in every possible manner. Government officials in their joint meeting decided to create an expert committee on start-up taxation with members from institutions such as IIM and IIT. Who will make recommendations on issues relating to recognition of start-ups for exemption from share premium tax and other connected matters?

Laws are generally made to protect corrupt practices. This provision was introduced like an anti-abuse provision to curb the practice of politicians accepting bribes in the guise of share premium in unlisted companies set up by them. However, the new age entrepreneurs are trapped unknowingly and are struggling to deal with such notices, with little cash flow.