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Economy

Angel Investors Beware: Funding Startups Could be Classified as Income

Startups, founders and Angel investors, please note the change in Budget 2012 that has been slipped in, innocuously. An investment in any private company could be classified as “income” unless you can justify the investment and valuation to a tax officer. Such income is taxable.

Look at the “Memorandum” under section “Share premium in excess of the fair market value to be treated as income” (Page 8).

It is proposed to insert a new clause in section 56(2). The new clause will apply 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. In such a case if the consideration received for issue of shares exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares shall be chargeable to income tax under the head “Income from other sources. However, this provision 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.

Usually a startup gets funding from an angel investor in exchange for equity. The valuation of the startup is usually based on an idea, with very little else to support it. (Hardly any computers or machinery or even hard investments by the founders). A new startup with an idea and perhaps a prototype built at home may get a Rs. 10 lakh funding from an angel investor for 10% of the company.

Typically, such startups have very little invested capital. So let’s assume the above startup had Rs. 90,000 as paid up capital by the founders, or 9,000 shares of face value of Rs. 10. To give the new investor 10% of the company, the startup will issue 1,000 shares (1,000 out of a total of 10,000 shares – the old 9,000 plus the new 1,000 – is around 10%).

Since the investor pays Rs. 10 lakhs for 1000 shares, he gets the shares at a value of Rs. 1000 per share. The “face value”, though is Rs. 10, so the investor has paid more than the face value. Startups are generally private. Finally, the investor is an Indian resident.

With those three conditions met – and they will be met for most angel level investments in India – the income tax department may not classify the money received as an investment, from April 1, 2012. They can say, listen, this is “income” to the company on which the company must pay tax.

(Paying tax is not a good option. The angel invests X, the startup pays 30% of X to the government; a 30% waste of good money, if you ask me.)

And if you’d like to argue otherwise:

Further, it is also proposed to provide the company an opportunity to substantiate its claim regarding the fair market value. Accordingly, it is proposed that the fair market value of the shares shall be the higher of the value—
(i) as may be determined in accordance with the 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 of its assets, including intangible assets, being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature.

You’ve spent all that time convincing an angel investor, now you can spend some more time convincing an Assessing Officer that your idea is an “asset” that is valuable enough.

Supposedly this rule was to avoid weird investments that would route shady money into equity of private limited companies. But like @tejus_sawjiani said: It’s like gassing a room to kill a mosquito.

What should you do?

If you’re a founder, either raise your capital from angel investors fast (before April 1, 2012), or try a workaround.

You can try a milestone based approach where each milestone will involve a valuation that can be justified (although I have little faith in a tax assessing officer’s ability to understand startup valuation based on implementation).

The other method is to use convertible debentures, where you take on the investment as debt, and as time goes by it converts into equity. This has the hurdle that the investment may be classified as equity on the whims of the tax officers, and at each conversion point to equity, the assessing officer needs to be satisfied about the valuation.

Another is to use a sweat equity approach. Say you give the investor shares at “face value”, and allocate yourself “stock options” that vest over the next two years, and give you additional shares equivalent to 90% of the company. This removes the problem of this clause, but introduces the problem that you have been given stock worth a large sum, for no consideration – is this taxable as income? Can you do this easily? I don’t have answers offhand.

New thought: Since the law applies only to companies, you might be able to start a Limited Liability Partnership where there is no concept of “shares”. Later when you are ready for a VC fund you can create a company and transition assets. (Note: transferring assets like knowledge or money which can be removed and reinvested, is easy. Transferring real assets like property and even tables and chairs will involve stamp duty and/or capital gains taxes which can be expensive. But for service oriented startups which don’t have too many assets, this may be an avenue to consider. However, note that a single tiny amendment will easily include LLPs into the ambit of this rule.

Finally, just find a non-resident angel investor, or pitch to a Venture Capital fund. This sucks, but it’s a problem our budget has given us.

If you’re an angel investor, consider creating an off-shore entity that can invest in startups. There are other issues with owning offshore entities as a resident; the Budget requires mandatory filing and then, can reopen your books for 16 years for scrutiny (versus six for a resident). Plus, the investment will be subject to wealth tax and if you get a great exit, you will be charged capital gains tax at 30%, and so on. It’s messy, but if you can, get a good accountant to validate the offshore approach.

(And please let me know! I can put it up here to help other angel investors).

Secondly, you can register as a VC fund. It’s painful but it absolves your investee companies from explaining things to a tax officer and so on.

Lastly, you can consider the alternate approach of using convertible debt. Just don’t call them “preference shares”. Or the sweat equity approach mentioned above. Also, a real accountant will have a usable opinion (I’m not an accountant).

This is a way to kill startups, cutting off what is a valuable source of funding. You might consider this is bad only for tech startups, but way too many startups, in all fields, start with money from friends, family and others, at a “higher than face” value. This is to account for the fact that the guy or girl on the ground is going to do all the work. Today, it doesn’t take too many physical assets to build a business, so capital comes in to hire people, rent an office, travel or advertise, but apparently the government would prefer you take a bank loan for this purpose than have your friends or colleagues pitch in for a potential equity state.

If either of you ever join politics and become a finance minister, please consider removing this clause.

New Related Items:

  • i have often got advise that an Indian start-up should find ways to incorporate company outside India & run the show. Reason being, the laws are always prone to change at whims & fancies + compliance is tedious.
    This, if implemented, looks a big dampener. i personally am aware of a few start-ups who have done this….not sure if those guys will be happy now, but chances are that they will be. In any case, angel investment environment is difficult & challenging. Now these guys just made it more expensive for angels & the companies themselves.

    Santosh

  • Rajesh says:

    Face value is not equal to fair market value (FMV) of a share.What is proposed to be taxed is only consideration received in excess of the FMV. The idea behind this is an investor would only bring as much money as determined by the FMV. Why can’t the startup prove that the FMV of a share is equal to what the angel investor pays per share?

    • You have to prove the FMV to a tax officer who isn’t likely to be qualified to understand the concept of early stage valuation. How would he value a facebook at the early stage? Wouldn’t he say – no, you have just an idea, investment must be at face value which is the FMV? This happens all the time, even well qualified CAs don’t know how to arrive at the large valuations that angels give to seed level companies. The idea of such investments is to leave enough on the table so that the founders remain interested, which is why some kind of leeway is given on the valuation; we can’t expect the tax officers to know each such case and evaluate it rationally. It also leaves room for abuse by the tax officers who can refuse your case and harass you to no end, with no proper rules to bar them.

  • Muthu says:

    In anycase, unless you are planning to take too much excess amount – that you don’t plan to spend, it shouldn’t be a problem? classifying as income doesn’t directly mean tax? you pay tax on profit – i.e. post your expenses.
    But of course considering investment as income is really weird from the finance point of view!

    • LEt’s say you take Rs. 10 lakhs of investment, and in the same year, generate revenue of Rs. 25 lakhs, with expenses of, say, Rs. 9 lakhs. technically, Rs. 16 lakhs is your profit. Tax department will say that 10 lakhs is “more than fair value” by say Rs. 8 lakhs. So tehy’ll add 8 lakhs to your profit, making it Rs. 24 lakhs and charge you 30% of that. Not fair at all!

      • Muthu says:

        In that case – pay your investors back and show it as an expense?
        [In any case…its too hypothetical to generate such profits in the same yr as investments]
        [Anyways, like I said – its too illogical to consider investment as income – something
        which means equity is income! then why at all have different heads?]

  • Rajesh says:

    Why will they say that? You are getting 16 lacs profit on your investment of 10 lakhs. You may even try to take an example of another public ltd. company in a similar industry and the PE at which its share is traded in the markets.

    • That’s the point. The rule says the 10 lakhs is not an investment, if you can’t prove that the “Fair Market Value” was 10 lakhs. If the assessing officer says the FMV was 2 lakhs, the rule adds the excess as income.
      The rules for valuation are to use assets, tangible or intangible. You might be able to get a different valuation if there is a specified rule (which there is not, at the moment). Given the way stock options are applied a valuation in the tax code, the rule is likely to be similar: that is, use a Cat 1 Merchant Banker Valuation for reference. but that hasn’t yet been specified, so your only option is to convince the assessing officer. Eventually, getting a Cat1 Merchant Banker valuation will not be cheap, but hopefully the ecosystem will work something out.

      • Rajesh says:

        You can always prove the FMV and we will hopefully know it in the fineprints. There is however an existing notification (NOTIFICATION NO 23/2010, Dated: April 8, 2010) for valuing unquoted shares and securities. You may find the details of this notification here – http://www.caclubindia.com/forum/notification-for-determination-of-fmv-u-s56-78062.asp.
        If you check the last clause(c) for valuing unquoted shares and securities, the FMV of unquoted shares and securities, other than equity shares in a company which are not listed in any recognized stock exchange, can also be estimated to be the price it would fetch if sold in the open market on the valuation date and the assessee may obtain a report from a merchant banker or an accountant in respect of such valuation..
        Thus, all that you as a startup might have to do is get the valuation done by an accountant or merchant banker and give a report to the tax man.
        And it is reasonable for the tax man to require the startup to get a valuation report from a qualified person.
        If I was the valuer, I might do this. Estimate the earnings (E) for the following years, determine the PE of listed companies in the same industry as the startup and apply such PE (avg. or the lower PE) to arrive at the FMV or market price (P) of an equity share in the startup.

        • Rajesh, at the seed level, you can’t estimate any earnings accurately. You can only take a wild guess. In fact, most seed level valuations happen with no income in sight for the next one or two years. There is no P/E if there is no earnings (profits). Merchant bankers have found it very difficult to value such companies anyhow.
          Secondly, that’s not what the clause says, I just read it carefully:
          …the fair market value of unquoted shares and securities other than equity shares in a company which are not listed in any recognized stock exchange can also be estimated to be the price it would fetch if sold in the open market on the valuation date and the assessee may obtain a report from a merchant banker or an accountant in respect of such valuation..
          What I have marked in bold above means that this clause does not apply to unlisted equity shares. You could apply it to unlisted preference shares, stock options (which are securities), RSUs, or other such shares. The equity share valuation is above in the link you specified.

          the fair market value of unquoted equity shares shall be the value, on the valuation date, of such unquoted equity shares as determined in the following manner namely:-
          The fair market value of unquoted equity shares = (A-L) * (PV)
          (PE)
          Where, A= Book value of the assets in Balance Sheet as reduced by any amount paid as advance tax under the Income-tax Act and any amount shown in the balance sheet including the debit balance of the profit and loss account or the profit and loss appropriation account which does not represent the value of any asset.
          L= Book value of liabilities shown in the Balance Sheet but not including the following amounts:-
          (i) the paid-up capital in respect of equity shares;
          (ii) the amount set apart for payment of dividends on preference shares and equity shares where such dividends have not been declared before the date of transfer at a general body meeting of the company;
          (iii) reserves, by whatever name called, other than those set apart towards depreciation;
          (iv) credit balance of the profit and loss account;
          (v) any amount representing provision for taxation, other than amount paid as advance tax under the Income-tax Act, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto;
          (vi) any amount representing provisions made for meeting liabilities, other than ascertained liabilities;
          (vii) any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares.
          PE = Total amount of paid up equity share capital as shown in Balance Sheet.
          PV = the paid up value of such equity shares.

          This kind of valuation metric is horrendously inadequate for a seed or angel level funding (there won’t be any profit, or reserve, or much paid up capital!)
          If you say then that the company shouldn’t be valued so much, then I will tell you that is bunkum. The whole of Silicon Valley has been built on this principle, that you let founders go build companies and give them money, and leave them enough equity to make their effort worthwhile.
          Finally, the point is this: It’s stupid to do this law for multiple reasons. First, there are WAY too many startups with investments from friends, family or angels. In comparison with the “black money” funded startups, these regular startups are probably 1000:1 (even going by the number of cases that have been raised for scrutiny) The folks that have black money can easily route their money abroad and have a foreign entity invest back into the Indian company – in that case, this stupid valuation metric etc. is NOT EVEN REQUIRED! (it only applis if your investor is an Indian resident). Plus, the section 68 change already requires a company to have a record of where the investor got his money from – that is onerous but more understandable as a law. So effectively, this Section 56 clause (the one that needs valuation) does not prevent ANY money laundering, except by stupid people who can be caught using Section 68 anyhow.
          All it does is create enormous power in the hands of an IT Assessing officer to harass legitimate startups. Such discretionary powers are the root of corruption, and we must avoid creating such ambiguous laws completely. What would be best is to remove this law completely, by understanding that valuation is not something IT officers will ever understand, and therefore there is no incidence of tax when a company is invested into; this is the law all over the world, and it exists for a very good reason: common sense.

  • Nimish V Adani says:

    There’s a Facebook page to appeal against this unfair policy: https://www.facebook.com/NoStartupTax. Do join.

  • sam says:

    Total 10,000 shares => founders(90%) = 9000 shares and investor(10%)= 1000 shares
    if a investor pays Rs.10 lakhs for 1000 shares then the share value should be Rs.1000 per share.
    But why you have specified as “Since the investor pays Rs. 10 lakhs, he gets the shares at a value of Rs. 100 per share. ” for 1000 or 10% shares
    Please help me to understand this calculation…

  • Praveen says:

    So more bribe to those Assessing officers (for getting convinced) which will be shared all along the chain., so again govt proved it make rules complicated so the actual normal got vexed with these rules and is ready to pay what ever the govt officer demands.

  • alok says:

    Guys, this law comes into effect from 1st april 2013 and not 2012. so we have a window of 1 year.

    • No, this is a classic Income Tax problem. They use very weird concepts of “applies from”. The funda is that you will file returns from April 1, 2013 for the financial year FY 2012-13. So effectively, you file in an “assessment year” (FY 2013-14, since after April 1, 2013 is that year) for a “financial year” (FY 2012-13).
      When they tell you something applies from 2013-14, it means it applies for what you file then, but it will apply to investments done in 2012-13.
      See the memorandum and search for Section 56, this clause is at the end:

      This amendment will take effect from 1st April, 2013 and will, accordingly, apply in relation to the assessment year 2013-
      14 and subsequent assessment years.

      (If it applies for assessment year 2013-14, that means it applies to financial year 2012-13. )

  • Indus says:

    There are two ambiguities:
    1. Based on the proposal, it only applies to a person investing in a company. (I think this was proposed to prevent laundering of money between related parties where one party is an individual)
    2. Quoting from the memo, “..The new clause will apply where a company, not being a company in which the public are substantially interested..” Of course, a startup is future looking a breakthrough innovation in the larger good of the public which may be interested at a future date.
    If #1 is true, then this whole thing is a non-issue. Seldom a startup gets money from an individual but rather a company, LLP, etc. run by one or more individuals, often called a “syndicate”. This is always true in case of institutional funds like MA, IAN, etc. Professional angels create a new vehicle each time with a new startup.

    • Thanks Indus.
      1. “Person” is an all encompassing definition of sorts in teh IT act. See “2. Definitions” under http://law.incometaxindia.gov.in/DIT/. The point 31 says person is an “individual”, a HUF, a company, a firm or pretty much any taxable entity.
      2. Even the “in which the public are substantially interested” is part of the definitions page mentioned in 1 above. That does not include a company that might or might not go public at a future date. (And that definition is not tenable; any company doing anything can say public will be interested in the future…)
      Creating a new vehicle might still be a good idea, if SEBI can relax VC fund guidelines to include such vehicles. (I hope!)

      • Indus says:

        Another thing (I tweeted you as well) is this from the memo:

        However, this provision 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.

        A “VC Fund” is registered with SEBI. Now, what is a “venture capital company”? Can an SPV which invests in shares of unlisted “venture capital undertaking (aka “startup”) be called a venture capital company?

        • I don’t think so, since that means ANY company that invests in a startup can be called a venture capital company.
          The memorandum clarifies:

          However, even in the case of closely held companies, it is proposed that this additional onus of satisfactorily explaining the source in the hands of the shareholder, would not apply if the shareholder is a well regulated entity, i.e. a Venture Capital Fund, Venture Capital Company registered with the Securities Exchange Board of India (SEBI).

          Meaning, the answer to your question is no.
          They want it to be a well regulated entity and registered with SEBI. A VC registered with SEBI can be either a trust or a company, I guess, which is why they put in both types.

  • Rajesh says:

    Deepak, you are right. On the face of it, does look like the last clause c) applies to the fair market value of unquoted shares and securities other than equity shares in a company which are “not listed” in any recognized stock exchange. I actually considered it as “listed”.
    But then remember that the notification was not meant for this context. I just mentioned it to let you know the existing provisions for valuing unquoted shares (for example when they are gifted). They might not prescribe similar methods as this proposed amendment has introduced a new context.
    ======================
    Further, it is also proposed to provide the company an opportunity to substantiate its claim regarding the fair market value.
    Accordingly, it is proposed that the fair market value of the shares shall be the higher of the value—
    (i) as may be determined in accordance with the 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 of its assets,
    including intangible assets, being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any
    other business or commercial rights of similar nature.
    =========
    I am expecting them to prescribe a method for the purpose of (i) above. FMV is prescribed as higher of (i) or (ii).
    Regarding valuation, if the startup isn’t able to estimate earnings, it should at-least be able to estimate cash flows and use, say a discounted cash flow method for valuation. There should be at-least one reasonably acceptable method of valuation for arriving at their contribution of 10 lakhs towards 1000 shares in your example. No?
    What this has done is it would now become essential to involve an accountant or a merchant banker in arriving at the value (if one is not already involved) and his report should be good enough for the AO for the purpose of (ii).

    • Rajesh: I think you have suggested a way out – of getting valuation done by a merchant banker (which may or may not be acceptable but still, it’s a case by case basis thing). I personally think that route is fraught with error – they have a merchant banker valuation system, a tax officer valuation system (using assets mentioned in ii) and then a regular equity shares valuation system (mentioned in that link of rule 87U) It’s just a bureaucratic hassle, totally unnecessary, and doesn’t achieve ANY objective other than to harass startups. People who have black money will not be addressed with this clause – the real one is #68. This is a silly overreach of the tax department.
      Secondly, startup valuations at the seed/angel level are usually very hazy. Most times, abroad, they use partially convertible debt, which have had issues in the past in India so there are legal issues in using that route. But suffice it to say that valuation using discounted cash flow or a comparative P/E is not “justifiable”. With an idea, I might be able to prove to an investor that my startup is worth that much – he is in the space, he understands how the business works, he knows how hazy it is initially, and therefore will agree on a valuation primarily to ensure the startup kicks off and gets somewhere that gives more visibility. I can say I have a small idea of how startup valuations at the angel level work, having been part of the process at two startups and helping a couple others; and with whatever experience I have of dealing with accountants and tax officers, they will be darn difficult to convince. According to me it’s unnecessary; they cannot question how much I pay for say a mobile phone, why should they question how much I pay for a stake in a company? Who’s to say something is overvalued?
      Now about convincing a) a merchant banker or b) a tax officer. A merchant banker, at least a reputed one, is not going to just give a valuation okay just like that. But let’s say they CAN be convinced. That is not the real issue. The issue is that they have to be, and that they can put a spanner in your works. When they don’t have a right to. If you’ve convinced an investor about your valuation, it’s a deal between him and you; why should a third party come in at all? Is there a systemic impact? No. Is there an impact to ANYONE else because of the angel deal? No. Is someone else money involved? No. Then why should anyone else bother? If the angel investor wants, he can say “okay, get this vetted by a merchant banker”. That is fine. But not a compulsory thing by the tax dept.
      You might not be old enough to remember but earlier there was another system where the government would actually give you an okay for the “price of your IPO” in the stock market. You had to justify your company’s valuation to some random government officer. This was such a horrible policy that everyone heaved a sigh of relief when it went away. Why? Not because people “couldn’t” justify their valuation. But because it created too much power in an officer who was simply put, not qualified to understand valuation, and that power should not rest with anyone. This kind of overreach is like going back to pre-liberalization times.
      Eventually there are those that will argue for the regulation, but I think the industry’s fairly aware now that this is a bad thing. More coverage will help, and I think this clause should go completely, if we argue hard enough, it will. This “be the change” thing? It’s here.

  • Since angel investment is classified as Income. Doesn’t that mean that it will be netted against the operating expenses and startup will have to pay a tax only in the year when they turn a profit.
    So it really affects the startups carry forward losses. Assuming you are a tech startup that wont make a profit in 3 years then this clause has very little impact. At some point in year 4 or year 5 when the startup exhausts its carry forward losses the impact of this new tax will be felt.
    This is no consolation though. The idea of classifying investment as income is wrong in so many ways!!

    • Ankur says:

      But wouldn’t that require you to spend the whole investment amount within one financial year?

    • You’ve already answered the question 🙂 But here are some points:
      The problem isn’t after three years. Typical startups start seeing some revenue in year 1 and 2 (may not be operating profits). These will get added to the “income” that the investment was classifed as, and taxes might apply. Take a startup that takes in 10 lakh as investment which it spends, earning 5 lakh of revenues (from ads, or consultancy or even sales). The loss should be Rs. 5 lakh?
      ANswer: No.Assume that the investment was classified as income (not all of it, but say Rs. 9 lakhs was). Then you have the 5 lakh revenue. Total income: Rs. 14 lakh. Total spend: Rs. 10 lakh. Profit of Rs. 4 lakh on which you pay 30% tax.
      This isn’t a profit at all! Like you said, the opportunity is also in the carry forward loss – so the Rs. 5 lakh loss that I should have on the books should be adjustable against profits next year. But not so with this clause, so that’s the real cost.

  • Binny says:

    Thanks Deepak.
    Would you know which of the following steps of the financing need to be completed before March 31, 2012 so a startup doesnt need to pay tax on the angel investment from a resident –
    1. Termsheet signed
    2. Shareholders agreement signed
    3. Money wired to company’s account
    4. Share certificates issued
    Thanks

    • Forget everything else, just issue the shares and get the money wired. The tax man doesn’t understand term sheets or shareholders agreement. They will care about when your shares were issued, and when you received payment. Btw, I don’t know if this law is with retrospective effect (must check!)