The aura of rich startup ecosystem that flourished in the country last year gradually seems to fade away now. With no funding prospect available to entrepreneurs and the high valuations dwindling down to new heights, one more blow, possibly the biggest of all, comes in the avatar of tax.
The income tax department has been discussing a controversial move to levy a tax on those startups whose valuations have fallen recently on the grounds that the first premium was more than the firm’s fair value.
Tax officials state that Section 56 of the ‘Income Tax Act’ confers on them the power to levy excess consideration, more than the fair value, against the issue of shares.
Section 56 (2) (vii) (b) of the Income Tax Act says, “Any consideration received by a company (start-up) from a resident, against issue of shares, exceeds the fair market value of such shares, such excess consideration is taxable in the hands of the startup, as an income.”
Many startups have seen their valuation fall sharply in recent times on worries over profitability, growth and intense competition. Tax officials are of the opinion that startups should be valued on the basis of the last round of investment. If this round’s valuation, however, is lower than the first round, excess premium, then more than the fair value is deemed to have been paid.
This move, however, is not likely to affect a vast number of startups, especially those which are funded by venture capital funds registered with the Securities and Exchange Board of India. It will most likely affect only those investments made by funds not registered with Sebi and by angel investors.
Having sensed the progress after tax officials have sent requests seeking detailed valuation reports from each round of investment, startups have already started taking steps to protect itself against it. No formal notices have been issued yet.
Amit Maheshwari, Partner, Ashok Maheshwary & Associates LLP, said, “There has been a long-standing demand by the industry that the government should either do away with the angel tax or provide a monetary threshold for an exemption for startups.”
“With down rounds becoming a reality now, there is a concern that some of the resident angel investors could see their prior investments which were done at higher valuations in startups, getting taxed under Section 56 of the Income-tax Act, 196 in the hands of the company as the tax officers may take the current valuation as the basis for valuing the prior investment,” he added.
For example in many startups, the first round of investment would have been made by an angel investor at a valuation of 2X, the second round too by a VC at 2X. But a private equity investor could have come in at 1X. The revenue department, in this case, would calculate the fair value of the startup based on the private equity’s investment and tax could be slapped on the investment made by the angel investor.
These steps are taken because tax officials say many in the past had misused the route of paying the premium for converting unaccounted cash (black money) to legal money (white).
An income tax office officer told ET, “We have seen cases, where people would start a company and through their friends, get their black money invested in the company at a premium. I do not see random adjustments against startups, but due to lack of transparency in valuations, we have asked past and present valuation reports from some startups.”
It could happen in the current fiscal, said he.
The government in the past had insulated VCs and funds from the Income Tax act (Section 56 2viib). While a demand was also made to shield angel investors from this, it is also been said that even incubators should be insulated, though the definition of what consists of an incubator is still missing.
Approaching consultant and lawyers were the first thing startups thought to fear a notice being slapped. Archana Khosla Founder Partner Vertices Partners, a law firm specialising in working with the startups, said, “The industry was hoping that angel investors would also be exempted from the said tax. However, the lack of implementation of any such exemptions is acting as a major impediment for startups.”
The emerging problem of many startups seeing their valuation dipping down has originated this controversy with taxes. In the last year or so even the unicorn startups have seen their valuations dipping.
Until recently, the valuation exercise of the funding received by startups was happening at their value based on projected sales, future free cash flows, exponential future growth and various other metrics all taken into consideration.
Maheshwari says, “Now, since the subsequent rounds of funding are happening at a lower valuation for many startups, tax authorities can dispute the earlier valuation, pulling it down by questioning the basis, correlating it with the current valuation and demand tax on the price perceived to be overpaid in the first round.”
