Angel Tax and Exemption to Start-Ups from Angel Tax

Introduction

Section 56(2) (viib) of the Income Tax Act, 1961 has been a cause of concern for the start-ups due to the tax levied under this section on the capital raised by the start-ups in India. This section was actually introduced for preventing money laundering activities by issuing shares at an excessive premium above the fair market value (FMV) of the shares. This is commonly known as “Angel Tax” but the section became a nightmare for the newly thriving start-ups who needed funds for fulfilling their aspirations.

However, the Government later issued a notification dated 19.02.2019 giving adequate relaxations for the eligible start-ups from the ill-effects of “Angel Tax’. This article is dedicated to the detailed evaluation of section 56(2)(viib) of the Income Tax Act from the perspective of the angel tax exemption for start-ups.

Reasons for introduction of Angel Tax

The main reason for the introduction of the ‘Angel Tax’ was to tax the excessive share premium received over and above the FMV by the private companies, which was extensively being used as a mechanism for accounting for unaccounted money or black money. Thus, this is one of the anti-abuse provisions introduced to prevent money laundering.

Section 56(2)(viib) to be read as follows

Consideration received in excess of FMV of shares issued by a closely held company to be treated as income of such company, where shares are issued at a premium

Section 56(2)(viib)

(a) Section 56(2)(viib) brings to tax the consideration received from a resident person by a company, other than a company in which public are substantially interested, which is in excess of the fair market value (FMV) of shares.

(b) Such excess is to be treated as the income of a closely held company taxable under section 56(2) under the head “Income from Other Sources”, in cases where consideration received for issue of shares exceeds the face value of shares i.e. where shares are issued at a premium i.e., (Issue price of share – FMV of such share) x No. of shares.)

(c) Fair market value of the shares shall be the higher of, the value as may be –

• determined in accordance with the prescribed method i.e. Net Asset Value Method; or
• substantiated by the company to the satisfaction of the Assessing Officer, based on the value of its assets on the date of issue of shares.

Note : For the purpose of computation of FMV, the value of assets would include the value of intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature.

(d) However, these provisions would not be attracted where consideration for issue of shares is received

• by a Venture Capital Undertaking (VCU) from a Venture Capital Fund (VCF) or Venture Capital Company (VCC) or a specified fund
  
  
• Specified Fund” means a fund established or incorporated in India in the form of a trust or a company or a limited liability partnership or a body corporate which has been granted a certificate of registration as a Category I or a Category II Alternative Investment Fund and is regulated under the Securities and Exchange Board of India (Alternative Investment Fund) Regulations, 2012 made under the Securities and Exchange Board of India Act, 1992.
  
  
• "Trust" means a trust established under the Indian Trusts Act, 1882 or under any other law for the time being in force
  
  
• by a company from a class or classes of persons as notified by the Central Government for this purpose.

Accordingly, the Central Government has, vide Notification No. 13/2019, dated 5-03-2019, notified that the provisions of section 56(2)(viib) shall not apply to consideration received by a company for issue of shares that exceeds the face value of such shares, 

if the said consideration received from a person, being a resident, by a company which fulfills the conditions specified by the Ministry of Commerce and Industry in the Department for Promotion of Industry and Internal Trade and files the declaration referred to in the said notification. In effect, vide this notification, the Central Government has notified the conditions to be fulfilled by a company which issues shares rather than the class or classes of persons to whom such shares are issued. 

Exemption from Angel Tax

The Ministry of Commerce and Industry in the Department for Promotion of Industry and Internal Trade has, vide Notification No. G.S.R. 127(E) dated 19.2.2019, specified in para 4 thereunder, that a startup shall be eligible for exemption under clause (ii) of the proviso to section 56(2)(viib), if it fulfills the following conditions:

(i) It has been recognized by the Department for Promotion of Industry and Internal Trade as start up as per this notification or any earlier notification on the subject.

(ii) Aggregate amount of paid up capital and share premium of the startup after issue or proposed issue of shares, if any, does not exceed, 25 crore.

However, in computing the aggregate amount of paid up share capital, the amount of paid up share capital and share premium of 25 crore rupees in respect of shares issued to any of the following persons shall not be included:

• a non-resident
• a venture capital company or a venture capital fund

Further, consideration received by such startup for shares issued or proposed to be issued to a specified company shall also be exempt and shall not be included in computing the aggregate amount of paid up share capital and share premium of twenty five crore rupees.

For this purpose, a specified company means a company whose shares are frequently traded within the meaning of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 and whose net worth on the last date of financial year preceding the year in which shares are issued exceeds one hundred crore rupees or turnover for the financial year preceding the year in which shares are issued exceeds two hundred fifty crore rupees.

(iii) It has not invested in any of the following assets –

• building or land appurtenant thereto, being a residential house, other than that used by the Startup for the purposes of renting or held by it as stock-in-trade, in the ordinary course of business
  
  
• land or building, or both, not being a residential house, other than that occupied by the Startup for its business or used by it for purposes of renting or held by it as stock-in trade, in the ordinary course of business
  
  
• loans and advances, other than loans or advances extended in the ordinary course of business by the Startup where the lending of money is substantial part of its business;
  
  
• capital contribution made to any other entity
  
  
• shares and securities
  
  
• a motor vehicle, aircraft, yacht or any other mode of transport, the actual cost of which exceeds ten lakh rupees, other than that held by the Startup for the purpose of plying, hiring, leasing or as stock-in trade, in the ordinary course of business
  
  
• jewellery other than that held by the Startup as stock-in-trade in the ordinary course of business
  
  
• any other asset, whether in the nature of capital asset or otherwise, of the nature specified in section 56(2)(vii)(d)(iv) to (ix) i.e., archaeological collections, drawings, paintings, sculptures, any work of art or bullion.
  
  However, the Startup should not invest in any of the assets mentioned above for the period of seven years from the end of the latest financial year in which shares are issued at premium

Meaning of Startup

A company would be considered as Startup if the following conditions are satisfied

(a) Period – It would be considered as a Startup upto a period of 10 years from the date of incorporation/ registration, if it is incorporated as a private limited company (as defined in the Companies Act, 2013) in India.

(b) Turnover limit - Turnover of the company for any of the financial years since incorporation/registration has not exceeded 100 crore rupees.

(c) Object and Purposes - The company is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.

However, a private limited company shall not be considered a “Startup”, if it formed by splitting up or reconstruction of an existing business.

Note: It may, however, be noted that where the provisions of section 56(2)(viib) have not been applied to a company on account of fulfilment of conditions specified in the above notification and such company fails to comply with any of those conditions, then, any consideration received for issue of share that exceeds the fair market value of such share shall be deemed to be the income of that company chargeable to income-tax for the previous year in which such failure has taken place.

Further, it shall also be deemed that the company has under-reported the income in consequence of the misreporting referred to in section 270A(8) and 270A(9) for the said previous year. Consequently, penalty @200% of tax payable on under-reported income would be leviable.