Section 56(2)(viib): A Tax is not the best form of defence
An in-depth analysis of the history, impact and future of the Angel Tax
“Perhaps the government thinks that a tax is the best form of defence.”
— Yes Minister, The Economy Drive
In the government’s zeal to eradicate black money, India is witnessing an archaic law being misused to target the very heart of startups: their capital. The “Angel Tax “(section 56(2)(viib)) was envisioned in a different era in an entirely different context, but has now come to represent the failings of the bureaucracy to keep up with an ever evolving ecosystem. To understand why the government seeks to tax capital receipts as revenue, we need to explore the context and history behind this section.
In 2012, during the UPA government’s tenure, India witnessed the introduction of the “angel tax” and Section 68 through the following words of Shri Pranab Mukherjee’s in his last budget to parliament:
“I propose a series of measures to deter the generation and use of unaccounted money. To this end, I propose:
Increasing the onus of proof on closely held companies for funds received from shareholders as well as taxing share premium in excess of fair market value.”
The reason for this harsh insertion was due to the Enforcement Directorate uncovering several transactions involving Jaganmohan Reddy wherein people had “paid bribe to Reddy in the form of investments at exorbitant premiums in his various companies to the tune of Rs 779.50 crore apart from making payment of Rs 57 crore to him in the guise of secondary purchase of shares and donation of Rs 7 crore to YSR Foundation” (PTI link).
To counter this, the 2012 Finance Bill had tabled exclusive measures to “prevent generation and circulation of unaccounted money”. This saw the introduction of a slew of measures such as sections 56(2)(viib) — taxation of premium in excess of fair market value, section 68 — unaccounted cash credits, section 69 — unexplained investments, etc. The budget memo accompanying the insertion of these sections also states, “the pernicious practice of conversion of unaccounted money through masquerade of investment in the share capital of a company needs to be prevented”
Thus was born Section 56(2)(viib), also called the “Angel tax”section.
This section taxes the difference between the price at which securities are issued by a private company and the fair market value of those securities. The concept of taxing capital receipts and investments as income is unique in the principle of taxation and exists only in India in this clause. The Fair Market Value is determThough the law offers the choice of valuation to the assessee company, what we’re witnessing is the Assessing Officers disregarding this freedom and instead of taking it upon themselves to value the Company, like an investor would (without putting the requisite capital behind this themselves). These officers ignore the valuation report prepared by a Merchant Banker of Chartered Accountant in favour of the current net-worth of the Company. Not even listed companies trade at their book values since this value is a historic one, whereas the valuation of the company is supposed to take into consideration future growth and earning potential as well.
Futhermore, to establish the creditworthiness of the investor (Section 68), the Assessing Officers are demanding the bank statements, Income Tax Returns and financial statements of all the investors from these Companies. Given the sensitive nature of these documents, not investor feels comfortable sharing them with their investee company. In spite of the tax department having these documents on record, which can be accessed by them via the Investor’s PAN, these heavy demands are made of the Companies with a very narrow timeframe to obtain these documents. If this continues to be the state of affairs, the angel funding ecosystem, which has seen a decline of 48.5%, from 653 investors in 2016 to 343 in 2018, will ultimately dry up. Angel funding is the highest risk strata of funding since these companies are just starting off or just developing their product or go-to-market strategy. While the UK, Singapore, the US etc have schemes and tax breaks to incentivise angel investors, India is taking a regressive step to dissuade angels from investing in these companies. Ironically, these measures of sections 56(2)(viib) and 68 only apply to domestic investors and not to non-resident investors. This discrimination against domestic investors is one of the reasons why domestic capital forms such a small part of the capital pool investing into startups in India.
But is the legislative intent to tax unaccounted money received as premium or any and all share premium received by startups?
A legal test to analyse this comes from Heydon’s Rule (1584), which requires the consideration of four matters in constructing any piece of legislation:
- What was the law before this enactment?
- What was the mischief of defect for which the law did not provide?
- What was the remedy that the enactment provided?
- What was the reason for this remedy?
The 2012 budget memo titled” MEASURES TO PREVENT GENERATION AND CIRCULATION OF UNACCOUNTED MONEY” actually provides answers to all these questions.
- What was the law before this enactment?
- There was no single law before the enactment of these measures and, to cite the memo, “Certain judicial pronouncements have created doubts about the onus of proof and the requirements of this section, particularly, in cases where the sum which is credited as share capital, share premium etc.”
2. What was the mischief or defect for which the law did not provide?
- The mischief for which the law didn’t provide was “the pernicious practice of conversion of unaccounted money through masquerade of investment in the share capital of a company”
3. What was the remedy that the enactment provided?
- The remedy the enactment provided was the insertion of section 56(2)(viib), 68, etc to “deter the generation and use of unaccounted money”
4. What was the reason for this remedy?
- The reason for this remedy was to create legislation and measures to “prevent the generation and circulation of unaccounted money”
Thus, this begs the question: why is a law meant to prevent the conversion of unaccounted money being used against all startups raising capital from known sources through bank transfers? It is clear that the legislative intent is to prevent unaccounted funds from being laundered and not to tax any and all share premium as income.
Yet this intent is being subverted and used as a weapon against all startups indiscriminately purely on the basis of a high share premium. A high share premium is not the cause of a high valuation but the outcome of valid business decisions regarding the face value and capital base of a company. Furthermore, a relative high share premium paid through accounted funds via bank transfers and proper compliance filings forms the antithesis of unaccounted funds that is at the heart of this legislation.
This is best shown by the following example:
Startup A chooses to begin its journey with an initial capital of Rs 1 lakh. The balance sheet after incorporation would be:
The Founders bootstrap the business through personal loans or further equity until they can attract angel funding. They choose to fund the initial operations with a loan of Rs 2.25 lakhs.
Their financials before any funding round would be:
Startup A manages to attract angel funding at Rs 1 Crore at a post-money enterprise valuation of Rs 10Cr (arrived at via Discounted Cash Flow) from various angel investors
- Share base: 10,000 shares
- Face Value: Rs 10 each
- Post-Money Enterprise Valuation: Rs 10 Crore
- Share Issue Price: 10 Crore/10,000 shares = Rs 10,000
- Share Premium (Issue Price — Face Value) — Rs 9,990
Whereas the book value prior to funding would be determined as follows:
Post the Rs 1 crore round of funding, the financials would resemble the following:
Thus, Startup A, with a Net Asset Value of negative Rs 15, raised capital at a share premium of Rs 9,990, a difference of 666x!
This shows how a high share premium is the consequence of the mathematics underpinning valuation, not a cause of high valuations.
So instead of taxing an outcome of a calculation, shouldn’t the government tackle the root case: unaccounted funds?
Since 2012, there have been numerous changes to Indian law to tackle this menace including:
- Introduction of a new Company’s Act in 2013 which mandates the use of wire transfers and providing the PAN for any investment
- Changes to the Prevention of Money Laundering Act, 2002
- Introduction of General Anti-Avoidance Regulations (GAAR)
- Mandatory linking of PAN and Aadhar to bank accounts (through Aadhar is no longer mandatory after the SC verdict)
- Multiples changes to the Income Tax Act, 1961 to prevent cash dealings
Yet this measure still remains — a thorn in the side of startups and a bed of nails for the government.
India has 39,000 active startups who have created 130 billion dollars of value through investments of 38.5 billion dollars from January 2014 — September 2018, as per the recently published Inc42 report titled “The State of the Indian Startup Ecosystem”. The tragedy is that only 10% of this amount is from domestic sources, with the ratio being heavily skewed towards angel and early stage investments, who end up bearing the brunt of the angel tax fallout. Even the section in question discriminates against Indian investors by specifically targeting them and excluding all foreign investors from its ambit.
No other country in the world taxes capital receipts as income in this fashion, or view share premia as a cogent indicator of unsavoury dealings and laundering. India has historically been a capital-starved nation, but instead of incentivising domestic pools of capital, we have in place laws that actively discriminate against Indian investors.
But to the credit of the Indian entrepreneur, India has risen to become the third largest startup ecosystem in the entire world not because of our laws, but in spite of them! Startup India is the first concrete step taken by the government to acknowledge the startup revolution taking place, but the Angel Tax threatens to undo all the good that the scheme has done.
After all, a tax is not the best form of defence.
