When the Hon’ble Prime Minister announced the Startup India campaign in 2015, one would have not realised that the seeds of the tax disputes on equity infusion in startups were sown back in the Finance Act of 2012. Bundled under the measures to prevent generation and circulation of unaccounted money, a Special Anti-Avoidance Rule (SAAR) in section 56(2)(viib) was born. Section 56(2)(viib) applies in the cases of closely held companies and works under a presumption that where any share capital is issued at a price which is in excess of its fair market value, it is a case of avoidance.
The difference between the issue price and the fair market value is taxed in the hands of the company as income from other sources at the rate of 30 per cent. Consequential levy of interest and penalty may or may not follow. In practice, section 56(2)(viib) has worked splendidly and has gone on to dramatically reduce such tax avoidance schemes. Staring in the face of a 30 percent flat tax, such innovative schemes have dwindled. However, the SAAR does not fail the law of unintended consequences and has led to taxes being levied on genuine capital infusion transactions where there was no tax evasion or avoidance to begin with. The taxpayers most adversely affected by this provision are ironically, startups.
Startups, especially technology based startups face challenges in satisfying the test of fair market value. Investments in such startups are made using assumptions about the business model. While such valuations may be high, if computed using the book values, there is an obvious mismatch. This leads to disputes with the tax authorities who do not agree with the judgment call of the investor but instead try a more conventional approach to valuation. Nevertheless, determination of fair market value of the shares itself is an issue. Though there exists a mechanism for valuation of the equity shares for the purpose of section 56(2)(viib), it has been challenged by the authorities.
Problems are especially faced by startups where the initial valuation was high but for the subsequent rounds of funding was revised downward. The authorities contest that this is a clear case of issue of shares in excess of the fair market value. Instruments like preference shares, which are usually issued by startup companies, do not find a specific valuation mechanism at all. As such, these companies are subject to huge risk and considerable uncertainty while opting for capital infusion from residents.
Lately, the tax authorities have also started to investigate cases where shares have been issued to overseas investors. The authorities question the residential status of the overseas investors and seek documentary proof for the same. With the residential status of companies to be determined by the Place of Effective Management going forward, these tests will become more elaborate, time consuming and increasingly subjective.
Incomplete solution from the Government
The pain faced by the startups from the application of the law is considerable and the Government has acknowledged the same. However, the solution that the Government came up with the notification dated June 16, 2016 is incomplete. The notification allowed capital infusions to go through unhindered and untaxed in the case of startups but the exemption applies only to DIPP approved startups with further narrowed criteria which needed to be satisfied.
As such, a number of startups which do not necessarily satisfy the DIPP approval and/or additional criteria have been left high and dry. The notification also does not address situations where startups received capital infusions prior to 2016.
What could be done?`
The notification dated June 16, 2016 should be made applicable retrospectively in respect of capital infusions prior to 2016. Tax under the existing provisions gets triggered even in cases where the investor makes the investment in startups using his best judgment and there is no collusion or tax avoidance. A mechanism should be built in so that section 56(2)(viib) targets only the cases of tax avoidance and not genuine investments.
Investments made by venture capital funds and venture capital companies are not subject to the rigours of section 56(2)(viib). There is increasingly a case where the Government should notify a class of investors which will encompass genuine angel investors.
Investments made by non-residents are also not covered by section 56(2)(viib). However, some overzealous tax officers have questioned the residential status of the investors. The issue does not attain finality by simply submitting the tax residency certificate and the officers insist on further information regarding the Board of Directors meetings, etc. along with other documentation.
The Government should clarify that as for section 90, even for section 56(2)(viib), a tax residency certificate issued by the Government of a foreign country will be sufficient proof of such investor being a non-resident.
The startup story in India is just starting – taxing capital infusions will torpedo genuine investments which is undesirable from a policy perspective. The Budget is an opportune time for the Government to set things right to ensure that tax is levied on the startups within the spirit of the law.