Angels No More? Problems and Solutions To The “Startup Tax”

Lawyers at VakilSearch tell you more

As per the latest changes after the budget, it seems that every startup receiving angel investments needs to pay a tax on the amount it receives by way of an investment. Absurdly, this rule does not apply to venture capital funds, but only to angel investments.

This is by virtue of the amendment which is proposed to Section 56 (2) of the Income Tax Act. By this Amendment to Section 56 (2), the following change is going to be effected –

Any investment made into a company at a value which exceeds the fair market value of the shares of the Company will be treated as income from “other sources”, and therefore will be taxed at upto 30%.

As mentioned above, this rule applies only where the investment is made by an individual (and most, if not all angels are high net worth individuals).

If the investment into the Company is made by a Venture Capital Fund, which is not an individual, it will not attract the tax.

The only exception to this tax is where the investment made into the Company does not exceed the fair market value of the Company’s shares. So for instance, if the investor brings in 1 crore rupees for a 10% stake in the Company, he valuing the shares of the Company at 10 crores. Most companies, when they start, have their shares valued at Rs. 10 per share or Rs. 100 per share. Therefore, in most cases, the value of the investment is likely to be much higher than the fair market value of the shares in the Company.

The proposal is to give the Companies a chance to substantiate its claim regarding the fair market value, but this is quite absurd really – this “substantiation” is likely to be by means of projections, and how many of you trust the Income Tax department with your business plans?

All is not lost however, and neither has angel funding been brought to an abrupt end. The one obvious solution is that the investor has to bear the tax. So if the investor was planning to invest Rs. 1 crore in a promising start-up, he will now have to invest Rs. 1.3 crore to cover the 30% that will be lost to the tax.

There is another interesting way around this problem. As per Notification No. 23 of 2010, the Fair Market Value of unquoted shares and securities, (also called the FMV Value), is equal to the value which the shares would fetch if they were sold in the open market. This means that if you get a report from a merchant banker or a certified valuer that the value of the shares is a certain amount, you can prove that you have received only the fair market value for the shares, and you will be exempt from taxation. 

There are multiple modes of valuation, and they will take long to explain here. But to leave you with a cheery thought, you can go ahead and look for that angel investment.

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