[From Pixabay]
As somebody who spends much time with startup entrepreneurs, these are questions I face routinely.
- How can they tax me for raising money?
- Why am I being singled out for harassment?
- One notice after another, short deadlines to appear in person at the income tax office—whatever is going on?
- Why am I being forced to fabricate a business plan for my yet-to-be startup? I raised money basis an idea, not a business plan! Hell, I don’t even know if the business will be around next year.
- Why is every family member and friend who invested in my idea being asked to submit their income tax filings and bank account details to income tax officers from other wards? Why are my chartered accountants and tax advisors laughing their way to the bank with money I could have deployed in the business?
- I’m told it may just be more convenient to register my startup in another country and stay clear of this mess. Any thoughts?
“Welcome to the world of Angel Tax,” I mutter. But this tax is a “hell” startups and seed-stage investors can do without. It is a perverted one and one that the government, which tom-toms India as a startup nation ought to have fixed long ago. That they’ve recently announced changes to the application of the law is one thing. From what I can make out though, it may be inadequate. Most founders will start a business with the first few hundred thousand rupees coming in from friends and family. This money can be scrutinized under the garb of Angel Tax.
Whenever this tax was framed, it hasn’t evolved to cover angel investors—the people who don’t back a business plan, but the people who plan to build a business.
If there is one thing India desperately needs over anything else, it is more entrepreneurs. And if there are people willing to put their skin in the game and back those willing to muddy their hands, they don’t deserve harassment.
So what is this uniquely “Made in India” phenomenon called “Angel Tax”?
But wait. There is no such thing called Angel Tax. I won’t want to put the cart ahead of the horse though. Let’s first wrap our head around the idea of fair market value (FMV).
I like how Investopedia puts it: “In its simplest sense, fair market value (FMV) is the price that property would sell for on the open market. A term commonly used in tax and real estate, fair market value has come to represent the price of an asset under the following usual set of conditions: Prospective buyers and sellers are reasonably knowledgeable about the asset, behaving in their own best interests, free of undue pressure to trade and given a reasonable time period for completing the transaction. Given these conditions, an asset's fair market value should represent an accurate valuation or assessment of its worth.”
When stripped of jargon what it means is, the FMV is the value you derive from the sale of any asset, if you made reasonable efforts to sell it at the highest possible value.
Now, let us assume you own an expensive wristwatch, which can potentially fetch Rs. 1 lakh in a marketplace, such as the classifieds section of a website. Instead, you decide to sell it to your friend, Mr. X, for Rs. 10,000.
Strictly speaking, you have under-valued the asset, and your friend gained much because he purchased from you below its FMV. You can argue it is your choice to sell the watch at any price you want. Who is to stop you from that? Right?
Wrong. Because only two things are certain in life: Death and taxes. Death comes once. A tax officer can visit multiple times. In India, when an income tax officer is armed with the Indian Income Tax Code and Section 56 in particular, the God’s angels may eventually feel sorry for you.
This, because Section 56 states that if there is any transfer of value between two entities, which is done either above or below the FMV, then the party benefiting in the value transfer is liable to be taxed for the difference.
So, in the case of the wristwatch, the officer can order a “fair value” assessment. Basis that, Mr. X (the recipient of the gain) can be ordered to pay a tax “as if” he profited by Rs. 90,000.
Not just that, Mr. X can expect a show-cause notice from the Income Tax department to explain how did he manage to acquire the watch at such a low price, and why ought he not pay taxes on his gains.
If unconvinced, interest or penalties can be applied as well. After all, he should have paid the income tax on the date it was due.
Now, the reason Section 56 exists is because Mr. X may not be your friend. He could very well be a watch dealer, who instead of paying you Rs. 1 lakh, actually paid you Rs.10,000 by cheque from his bank account, and Rs. 90,000 in unaccounted cash (black money). The officer can argue both of you colluded to avoid paying tax.
Now, substitute a wristwatch for any other class of assets: property, apartment, shares, bonds, etc. and apply the same logic. If two parties collude, they can transact above or below the FMV and create a way to avoid taxes. In many cases, even convert black (unaccounted) money into white (accounted) money.
I don’t intend to get into the nuances of how that game is played. Your friendly chartered accountant can offer a primer on that.
The job of the income tax officer is to lift the veil on such transactions and recover the tax due under Section 56. The first step then is to find out what is the FMV.
Once the income tax officer estimates the FMV and compares it to the transacted value, he can proceed to figure whether a transaction was bona fide or mala fide. If there is a gap between the two values, the onus of proving a transaction was bona fide lies on the persons under scrutiny.
When looked at from this perspective, there is no such thing called an Angel Tax. All that is happening is that the Income Tax department has gone overboard to apply Section 56 to the thousands of startups filing returns every year.
Now let’s consider your startup. Say you get an angel investor or a consortium of them to invest Rs. 1 crore for a stake of 10%. That values your startup at Rs. 10 crore (on a post money basis). You may or may not have presented a business plan. Like I said at the outset, people you know placed their money on your idea because they know you, your team, and have faith in the idea you have in mind. Actually, you also made reasonable efforts to value your startup at the highest price you could get, so that you dilute as little equity as possible.
At that moment, when they invest, your business is worth next to nothing. What you may have on hand is a loss-making entity. Sometimes, not even a business plan—just a kernel of an idea. But angel investors have the faith that you will be able to build a business that will be valued at far higher than Rs. 10 crore and they would earn multi-fold returns. In fact, most term-sheets at that stage rarely refer to a business plan.
Enter, the income tax officer. He doesn’t know you, the angel investors or your business. What he can see two years down the line when your tax returns are audited is a company with a paltry revenue line and a whopping share price.
Now comes the first twist.
How he determines the FMV of a company or assets are according to valuation rules specified under Rule 11 and its related sections under the Income Tax Act, 1961.
Let me make it simpler. Those rules and formulae to determine the valuation using methods like NAV (Net Asset Value), DCF (Discounted Cash Flow), etc. are designed to value a company with cash flows and a functioning business. But a startup is not yet a business. And that is where the problem lies.
On paper, as per the rules, the premium your investors paid looks suspiciously high. It looks like an over-valued sale of the shares of your company. Bingo, let’s apply Section 56 and ask questions later. Again technically, the beneficiary of the over-valuation is your company. Therefore, it is liable to pay the difference between the Rs 10 crore in valuation and the next-to-nothing FMV that your company actually commands under the formulae derived from Rule 11 (and its brethren).
The IT officer then sends out notices and insists everyone involved in the transaction prove their bona fides and justify the valuation.
What begins is a cycle of paperwork, personal hearings and meaningless valuation reports, which some people call “tax-terrorism”. Some startups I know got so tired of it, they actually paid up on the demands made, just to get the file closed.
On paper, the tax officer is correct. How does he know that you haven’t set up a shell company pretending to do business when in fact it is a vehicle to convert black money into white or to book fake losses? There is no way for him to know this looking at your tax filing. He is merely doing his job, albeit over-enthusiastically.
And that friends is the much-feared Angel Tax. It’s simply the inability of the IT officers to sit in their offices and assume that you are a bona fide startup, striving hard for survival. That the valuation your angels gave you is for the expectation that you’ll create a large business, and for the sweat you will put into building the business. The value is bona fide, the FMV is indeterminate.
If I were to take this argument to its logical conclusion, I will then assert that every company that decides to go in for an initial public offering (IPO) also ought to get these notices. This, because their FMV too is indeterminate.
It can be argued though that since the shares are distributed widely, the participants are not colluding to determine the price of an IPO, the price itself is assumed to be the FMV.
A similar reason holds when they see an institutional venture capitalist invest. It is unlikely that the transaction is not arms-length with a Sequoia or Nexus or Softbank.
So what’s the solution?
Asking the IT department to dilute the core purpose of Section 56 is not wise. There is enough and more fraud already taking place in India (in both public and private companies) and valuation is used often for these fraudulent transactions. Black and white money becomes easily interchangeable, and fake tax write-offs are created. The government had come down hard on shell companies last year, and stumbled across nearly three lakh of them!
Now, how can you prove that you, your startup and angel investors are bona fide partners? And that you traded in your shares at a price which reflected everyone's expectation of the future of your startup? What are the reasonable tests that the IT officer can apply which prove that you are building a business, and your fancily named firm is not a shell company?
There is a solution
1. Direction needs to go to the IT officer that their mindset needs to change from the presumption of guilt to the presumption of innocence. If it looks like a startup, smells like a startup, then it is a startup. In some cases, a quick search into the prior filings of an angel investor may be enough to give them a hint. Startup registration is another partial safeguard.
Even under existing laws, there is a solution. Do away with Section 56 altogether and use the provisions under General Anti Avoidance Rules (GAAR). This is a set of rules under the Income Tax Act which empowers the income tax authorities to deny tax benefits to transactions or arrangements that do not have any commercial substance or consideration other than achieving the tax benefits. These rules have in-built checks and balances which ensure an income tax officer has reasonable grounds before he or she starts sending out notices and summons.
It insists application of mind as opposed to application of formulae to determine whether a transaction was transparent and conducted at arms-length distance.
2. Under GAAR a startup has nothing to fear, since one of the most important tests that GAAR applies is that of “commercial substance”.
A business transaction is said to have commercial substance when it is expected that future cash flows of the business will change as a result of the transaction. Generally, in tax avoidance transactions there is always lack of commercial substance because they really have nothing to do with changing cash flows of the entity.
Section 97 of the Act deals with the following transactions which may be deemed to lack commercial substance:
- If the substance or effect of the arrangement as a whole, is inconsistent with or differs from, the form of its individual steps;
- The transaction may be deemed to lack commercial substance if it involves round trip financing, an accommodating party, elements that have the effect of offsetting or cancelling each other or a transaction which is conducted through one or more persons and disguises the value, location, source, ownership or control of funds which is the subject matter of such transaction.
Now if you have raised money for the startup and it has been deployed in the business with the intent to build it, and none of it has been “round-tripped”—i.e., returned to your investors or their related parties—then you have undertaken a bona fide transaction under GAAR.
The job of the income tax officer then shifts from figuring the why and how of the share premium to establishing if there has been any tax avoidance. In most cases, this can be done by looking at the profit and loss and balance sheet of the company, as well as a KYC of the investors, and examining for suspicious transactions.
In any case, fact is that if someone wants to launder a few lakh rupees, they are hardly going to the use the startup route. There are probably several other loopholes which invite less ongoing scrutiny. Thus, even the amounts involved can be a filter—seed stage investments are usually under Rs. 2-3 crore.
Finally, if anything, the government should be coming up with provisions that actually incentivise investments into startup businesses. Like, allow easy write-offs of the failures. Instead, it is doing just the opposite.
I write this piece ahead of the Department of Industrial Policy and Promotion (DIPP) Roundtable on Angel Tax on February 4. Hopefully, the authorities will see the light and we’ll put this matter behind us. The startup ecosystem has wasted enough time and money on it, and it’s time to get back to building business.
(Note: The wristwatch example above is for ease of explanation—strictly speaking, a watch wouldn’t be taxable. Practically, Section 56 provisions apply differently to different asset classes. Apologies to tax experts.)
Update: This article was updated on February 4, 2019, to include more information on the safeguards under GAAR.
