Drilling Down Further on Budget 2012 [For Startups]

4th Apr 2012
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Budget 2012 was expected to put a bruised and hurting economy back on the path of growth. A number of tax and policy initiatives had been proposed to foster growth and development. However, it seems that through the tax policy, the Government has dealt a big blow to all the ambitious entrepreneurs who wish to set up their own businesses, and are on the look out for investments (through angel investors).

The major concern for the start up community and the investors is the amendment to Section 56 of the Income Tax Act, 1961 ( Section 56 details the instances wherein income would be deemed as income from other sources) in the recently concluded budget. Section 56 (viib) of the Income Tax Act reads as follows:

Where a company, not being a company in which the 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:

Provided that this clause shall not apply where the consideration for issue of shares is received by a venture capital undertaking from a venture capital company or a venture capital fund.

Explanation.—for the purposes of this clause —

(a) The fair market value of the shares shall be the value

i. as may be determined in accordance with such method as may be prescribed; or

ii. as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares of its assets, including intangible assets, being, goodwill, know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature; whichever is higher.

Implications for Startups

Considering that majority of the start ups obtain funding through angel investors, the above provision could be a big blow to the dreams of young entrepreneurs.

Under this proposal, the government will treat all individual investments (which will also include genuine angel money) in a company as “income from other sources” in the hands of a company if the amount of investment by the individual investor exceeds the fair market value of the shares allotted to the individual investor. Such excess will be subject to tax at 30 per cent in the hands of the companies (including all genuine startups).

However, it is pertinent to note that the method of determining the Fair Market Value (“FMV”) is yet to be prescribed.

Another matter of concern would be the fact that the Income Tax Officers have been vested with the right to decide on share valuations. Simply put, the Income Tax Officer is given the power to reject the share valuation prepared by the company and could proceed with his own calculation of FMV of the share and further the value arrived at by him would be considered as the FMV for income tax purpose. The bias, therefore, by the tax officials is likely to tilt towards a lower FMV as it would imply higher tax collection.

To add to the woes of the start ups, the government has thought it fit to empower the revenue authorities to use a free hand in determining the market price of the share.

However, in what could be seen as a relief to the start ups, and as per sources in the industry, it is understood that members of the angel investment community along with a few top consultants have met officials from the Finance Ministry. While the government is unlikely to withdraw the entire provision targeted at curbing money laundering and tax evasion, an amendment stating that deals under Rs 5 crores individually and Rs 10 crores overall, will be exempt, is finding favour with the officials. Therefore, this would imply that start ups availing investments up to Rs 5 crores would not be taxed. This will solve the problem to a large extent as a majority of the angel investments fall in the bracket of ten lakhs and two crores, which is less than 5 crores.

It would also be pertinent to note that the venture capital investments would not be covered under this section and therefore investments by Venture Capital Funds and Venture Capital Companies would be exempt.

Other Reliefs

Relief from long-term capital gains tax on transfer of residential property, if invested in a manufacturing-SME

The other provision which could be of interest to the start up community would be the introduction of section 54GB.

A new section 54GB has been introduced to provide relief from long term capital gains tax to an individual or an HUF on sale of a residential property (house or plot of land) provided the individual invests the sale consideration received, in the equity of a new start-up SME company in the manufacturing sector.

Therefore, the introduction of this section should encourage individuals to invest in startup companies, albeit in the manufacturing sector. The introduction of this section comes as a breath of fresh air which would have received more cheers had it been extended to all sections of the startups instead of limiting it to the manufacturing sector only.

Provisions relating to Venture Capital Fund (VCF) or Venture Capital Company (VCC)

Presently, section 10(23FB) provides that the income of a Venture Capital Fund (VCF) and Venture Capital Company (VCC) is exempt from tax, provided the Venture Capital Undertaking (VCU) is engaged in only nine specified businesses. In a significant relief to the venture capital industry, Section 10(23FB) and section 115U are proposed to be amended to provide that the income of the VCF or VCC from the investment in VCUs would be exempt irrespective of the sector of the VCU.

Doing away with the restrictions on the areas of business of VCU, would help in attracting the VC investments in various areas which are in need of funding.

To conclude, one would hope that the proposed amendments would be implemented to give a much needed fillip to the aspiring entrepreneurs. The law in its current form is far from encouraging. The zeal and vision of the budding builders of our economy is in dire need of Governmental assistance to build but not shatter their dreams and aspirations of taking the country on to new heights of prosperity. However, there is still a ray of hope that all these issues would be clarified by the Finance Ministry in due course. Surely, the intention of such a law was never meant to stop investments in start ups. We certainly hope that the Government would come out with a clarification at the earliest.


About the author:

This article is presented by Sandeep Arinaya , a Chartered Accountant by profession and the director of Merican Consultants Private Limited, a professionally managed company providing a wide range of financial services which include maintaining the books of accounts of companies, tax and regulatory services, certification services , Company Secretarial services. Merican Consultants Private Limited serves as a one stop shop especially for start ups for all their financial solutions in the fields of accounts, tax, payroll, regulatory and other advisory services.

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