Budget Amendment Proposes Startup Tax - Its Interpretation andPossible Way Out

Budget amendment which brings in a provision via section 56(ii)(viib) is the talking point post budget at every startup forums, be it digital or print media. Thus, we thought of coming up with a write-up, to understand the legal interpretation and also possible way out for startups and investors.

To start with, the objective of this amendment is not to cause hardship by taxing genuine startups, but to unearth and tax such undisclosed money, which was getting channel into the system without paying proper taxes due to flaw in the laws.

What Is Section 56(ii)(vii)(b) As Proposed to be Brought In

The proposed law says that, “Where a company, not being a company in which public are substantially interested, receives in any previous year from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the Fair market value of the shares will be taxable under the head ‘Other Sources’ in the hands of the company which receives such investment.”

Further, the provision goes on to say, that the Fair Market Value ‘FMV”, shall be, higher of below

• as may be determined under Rule 11UA of the income tax Act; OR

• as may be substantiated by the company to the satisfaction of the Assessing Officer based on the value of Goodwill, Know-how, Patents, Copyrights, Trademarks, Licenses, Franchises, or Any other business of commercial rights of similar nature.

Also, this law shall not apply where the consideration for issue of shares is received by a venture capital undertaking from a venture capital company / venture capital fund.

Here, it is very essential to understand, that there is a timing difference for trigger of this law and the basis of taxation. The law gets triggered when the consideration received is more than the face value of shares, whereas, the taxability will happen, when the consideration received exceeds the fair market value of shares, that is:

• Consideration/share > FV/share: Taxable event satisfied

• Consideration/share > FMV/share : Excess of consideration over FMV actually taxable

We have also tried to explain this law with help of a diagrammatic presentation:

Possible Way Out and Things To Ponder Upon

• The best way possible to deal with this law is to document the basis of investment by the angel funding house to a startup. It’s very evident that, when a startup gets funded, and at very initial stage, the investors have basically nothing to base upon the quantum of investment.

The investors should look to base their investment taking advantage of a window provided in the law via Goodwill, Know-how, Patents, Copyrights, Trademarks, Licenses, Franchises, or Any other business of commercial rights of similar nature and also taking advantage of fair market value concept. However, there is no denying the fact that, it’s an additional head-breaker and cost inflation.

• Another thing to note here is that, this law is proposed to trigger only, when, the investor is a resident, and thus startups should look to invite investment from abroad. Also, funding houses should look to associate with foreigner partners, and then route their money for investment. However, in detail analysis of foreign exchange laws is required here.

• This law is only applicable to domestic companies, so the investors can still initially look to invest in a LLP or a general partnership firms, and then, based on the growth pattern of the startup business, can look to convert the LLP or general partnership into a Company, if required.

• Another interesting thing about this provision which infact in some sense very similar to the transfer pricing provision, is that, the proposed law states that the methodology of computation of FMV is to be proved to the satisfaction of the Assessing Officer.

The provision is silent, though, about the timing, when the same needs to be substantiated before the assessing officer. Our understanding is that, the same needs to be proved only, when, the startup company is asked to do so, after the same has been picked up for scrutiny by Tax Department. Also, the cases picked up for scrutiny by the tax department are taken up for hearing round 2 years after the closure of the relevant financial year.

Thus, it provides enough time and opportunity for documentation of the same. Also, if the investor and the startup are confident about the valuation, there is no voluntary requirement to pay taxes on the investment by showing the same under the head ‘income from other sources’.

• Also, one school of thought suggests that fair market value of unquoted shares is nothing, but the price at which the same can be sold in the open market.

Thus, why the offer made by the angel funding house to invest a certain amount of money in a startup for a portion of stake, should not be taken as fair market value of the shares of such startup? If, this is to be relied upon, then this law falls on its face.

To Conclude

We are of the opinion that, this law seems to have been brought in with haste without proper application mind, would cast negative impact on the eco-system of startup companies.

Thus, the government should immediately bring in amendments to this proposed law, so that the objective of unearthing black money is achieved but not at the cost of disturbing the interest of startups and genuine small businesses. One way of that can be to bring in quantum of investment clause, similar to transfer pricing laws.

Startups and other businesses feel free to visit www.Taxmantra.com for comprehensive accounting, legal, regulatory, taxation and other compliance related assistance.