Angel Tax (Section 56(2)(viib)) has become a cause celebre in Indian startup circles due to its broad-reaching ramifications on all startups raising capital. This paper traces the origin of this section, it's analysis, impact, how it adversely affects startups. Special mention is also made of the seldom covered Section 68 and it's used in conjunction with Section 56(2)(viib). The paper also proposes recommendations to ensure that genuine companies are not aggrieved by this while the original intent of the section is preserved.

1. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
White Paper on Section 56(2)(viib) and
Section 68 and its impact on Startups in
India
Contents
Abstract...................................................................................................................................................3
History of the section..............................................................................................................................3
Section 56(2)(viib) and Section 68 ..........................................................................................................3
Analysis of the pertinent Sections: .........................................................................................................4
Section 56(2)(viib):..............................................................................................................................4
Applies to: .......................................................................................................................................4
Does not apply to:...........................................................................................................................5
Fair Market Value:...........................................................................................................................5
Section 68: ..........................................................................................................................................5
Linked to: ........................................................................................................................................5
Applies to: .......................................................................................................................................5
Does not apply to:...........................................................................................................................5
Current Situation afflicting Startups in India: .........................................................................................5
Share premia (Section 56(2)(viib): ......................................................................................................6
Source of Funds (Section 68): .............................................................................................................7
Disregarding the choice of the Valuation Method: ............................................................................7
Suggested Steps:.....................................................................................................................................8
Short Term measures:.........................................................................................................................8
Long Term Measures: .........................................................................................................................9
Link the MCA and CBDT databases via APIs so that the Startup India registration and capital
raise information filed with the MCA can be accessed by the CBDT:.............................................9
Modify the Tax Return Form for Companies to accommodate the DIPP registration number and
details of the capital raises with the CBDT .....................................................................................9
Introduce the Accredited Investor concept and modify ITR-2 and ITR-2A to include a schedule
for such investments by Accredited Investors................................................................................9
Modify Section 68 to allow the Assessing Officer to reach out to the Investors for any
information regarding the source of funds if this has not been declared in the investors’ tax
returns and filings ...........................................................................................................................9
Declaration that from the Company stating that the capital so raised has not been re-invested
into the Investor’s business or into any related party of the investor .........................................10

2. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
Conclusion:............................................................................................................................................10
About the Author:.................................................................................................................................10
Annexure A- Details to be added to the Income Tax Return of Companies.........................................11
Annexure B - Annual Form to be filed by any Accredited Investor or Tax Payer investing into Private
Limited Companies ...............................................................................................................................12

3. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
Abstract
The purpose of this paper is to provide a deeper understanding of sections 56(2)(viib) and 68 of the
Income Tax Act, 1961, the context behind the insertion of these sections, implications of the same on
Companies raising capital from investors and possible measures to mitigate the collateral damage
caused by the extension of the scope of these sections.
History of the section
“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.”
- Shri Pranab Mukherjee, Finance Minister
Sections 56(2)(viib) and 68 of the Income Tax Act 1961 were enacted into law by Shri Pranab
Mukherjee during his 2012 budget speech as a means of plugging the laundering of black money
through unlisted entities. They did this by exploiting then extant provisions of the Income Tax Act.
There were several cases of money laundering by Jaganmohan Reddy that were caught by the
Enforcement Directorate, who revealed that people had “paid bribes to Reddy in the form of
investments at exorbitant premiums in his various companies to the tune of Rs 779.50 crores apart
from making payment of Rs 57 crores to him in the guise of secondary purchase of shares and donation
of Rs 7 crores to the YSR Foundation”.
To prevent such abuses of the law, the government clamped down and stated that any unjustified
share premium given by a private company would be taxed as income in their hands and any
unexplained cash credit in the books of such companies would also be taxed in their hands. But this
had unintended consequences for Companies and startups in India, who always raised money from
investors at a premium. Over the past three years, many such Companies have received notices from
the IT Department with demand notices being issued against them for their capital raises.
Section 56(2)(viib) and Section 68
Section 56(2)(viib) of the Income Tax Act, 1961 reads:
“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—
(i) by a venture capital undertaking from a venture capital company or a venture capital
fund; or

4. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
(ii) by a company from a class or classes of persons as may be notified by the Central
Government in this behalf.
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 prescribed9
; 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,
licences, franchises or any other business or commercial rights of similar nature,
whichever is higher;
(b) "venture capital company", "venture capital fund" and "venture capital undertaking"
shall have the meanings respectively assigned to them in clause (a), clause (b) and clause
(c) of Explanation to clause (23FB) of section 10;
Section 68 of the Income Tax Act, 1961 reads:
“Where any sum is found credited in the books of an Assessee maintained for any previous year, and
the Assessee offers no explanation about the nature and source thereof or the explanation offered by
him is not, in the opinion of the Assessing Officer, satisfactory, the sum so credited may be charged to
income-tax as the income of the Assessee of that previous year:
Provided that where the Assessee is a company (not being a company in which the public are
substantially interested), and the sum so credited consists of share application money, share capital,
share premium or any such amount by whatever name called, any explanation offered by such
Assessee-company shall be deemed to be not satisfactory, unless—
(a) the person, being a resident in whose name such credit is recorded in the books of such company
also offers an explanation about the nature and source of such sum so credited; and
(b) such explanation in the opinion of the Assessing Officer aforesaid has been found to be
satisfactory:
Provided further that nothing contained in the first proviso shall apply if the person, in whose name
the sum referred to therein is recorded, is a venture capital fund or a venture capital company as
referred to in clause (23FB)of section 10.”
Analysis of the pertinent Sections:
Section 56(2)(viib):
Applies to:
• Private limited companies
• Issuing shares above their face value (ie, at a premium)
• To any resident Indians

5. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
• The consideration received for these shares is higher than the Fair Market Value of the
shares
Does not apply to:
• Non-resident investors
• Venture capital investment made by a registered venture capital fund
Fair Market Value:
• Determined as the higher of:
o The value determined by a Category I Merchant Banker (previously an accountant or
a Category I Merchant Banker), using the valuation methods stated in Rule 11UA(2)
of the Income Tax Rules (Rules), 1962, viz:
• Net Asset Value (NAV) method, as described under the Rules
• Discounted Free Cash Flow method
o The value substantiated by the Company to the Assessing Officer based on IP,
commercial agreements, intangibles, etc
Section 68:
Linked to:
• Directly linked to section 56(2)(viib)
Applies to:
• Any sum credited in the books of the Assessee
And
o The Assessee offers no explanation for the sum so credited
▪ OR
o The explanation so offered is not to the satisfaction of the Assessing Officer
In the case of section 56(2)(viib) (in addition to the above):
• The person against whom the credit appears offers an explanation about the nature and the
source of the funds
AND
• The explanation so offered is satisfactory to the Assessing Officer
Does not apply to:
• Non-resident investors
• Venture capital investment made by a registered venture capital fund
Current Situation afflicting Startups in India:
All Startups raising capital are getting struck with notices which resemble the following:

6. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
Figure 1
Figure 2
Figure 3
They all face the following 2 issues:
• Disallowance of the valuation report by the Assessing Officer based on the Book Value of
the shares (which does not take into account future earning potential and goes against the
choice of valuation method offered to the Assessee under Section 56(2)(viib) (Figure 1
above)
• Onerous proof of the source of funds of the investors so investing (such as asking for
sensitive documents of the investors like the Income tax Returns of the Investors, bank
statements, etc) (Figure 2 and Figure 3 above)
Share premia (Section 56(2)(viib):
• All Startups and private companies (Startup or Company) raising capital in India from Indian
investors issue shares at a premium (ie, above its face value)

7. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
• Such premia is offered by the investors who believe in a variety of factors, such as:
o Founding team and management
o Business Plan and Business model
o Sector of the Company
o Technology used
o Competition
o Target customer and pricing, etc
• The high share premia is the result of a mathematical function of valuation, ie, the total
value of the company (Enterprise Value) divided by the total outstanding shares of the
Company
• THE COMPANIES (AMENDMENT) ACT, 2015 (REGISTERED NO. DL—(N)04/0007/2003—15)
removed the minimum share capital requirements for starting a Company (previously, Rs 1l
for private limited Companies)
• Entrepreneurs are allowed to start Companies with very little initial capital invested by the
Entrepreneurs as they prefer to get external funding early on
• These investors, based on the above parameters, ascribe a valuation to the Company prior to
the investment and invest into the company at that valuation.
• The issue price of the shares is high due to the mathematical method of valuing these
Companies (stated above)
Source of Funds (Section 68):
• Any such funds raised by the Companies comes in compliance with the Company’s Act, 2013
and through 3 modes:
o Rights issue (Section 62(1)(a) of the Company’s Act, 2013)
o Private Placement (Section 42 of the Company’s Act, 2013)
o Preferential allotment (Section 62(1)(‘c) of the Company’s Act, 2013)
• There are Board minutes, Registrar of Company (RoC) filings for the above that need to be
made prior to the investment
• Any such money received comes via normal banking channels (bank transfer, cheque,
demand draft), as stated in the Company’s Act 2013
• The investors need to be clearly identified prior to the investment and need to sign the
necessary paperwork, kept on record with the Company and filed with the RoC, prior to any
investment
• Obtaining the PAN of the investors will allow the Tax Department to locate the Income Tax
Returns of the investors and to determine whether the Investors has sufficient declared funds
to make the proposed investment
• There is also case law from the Income Tax Appellate Tribunal attesting to the same (relevant
ITAT ruling)
Disregarding the choice of the Valuation Method:
• Section 56(2)(viib) offers the Assesse the choice of valuation method (Book Value method of
Discounted Cash Flow method)
• The section further states that the higher of the value determined by the valuation method
chosen by the Assessee of the value substantiated by the Assesee to the Assessing Officer
is the Fair Market Value

8. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
• However, in all cases of the use of this section against Companies, the Assessing Officer
disregards the valuation report based on the method choses by the Assessee and instead
determines the Fair Market Value as being the Book Value of the Company.
• There is case law and precedence which states that the Assessing Officer does not have the
power to insist that a particular valuation method eneds to be followed since the Act allows
for the Assessee to choose the most appropriate valuation methodology (relevant ITAT
ruling)
• Though the Act states that the higher amount will be the Fair Market Value, the Assessing
Officers are taking the lower amount as the Fair Market Value and taxing the difference as
Income from Other Sources in the hands of the Assessee Company
Suggested Steps:
These section of the Income Tax Act are being used to make roving inquires against all startups and
bestows significant arbitrary powers upon the Assessing officers. They should not be used against
against genuine Companies and entrepreneurs in their journey to create world-class Indian Companies
and generate employment. The following measures can alleviate the problems faced by genuine
startups in face of these notices:
Short Term measures:
1. The CBDT should issue a circular to all Assessing Officers stating that following:
a. The valuation method chosen by the assessee Company cannot be disregarded
b. A valid valuation report made by a merchant banker or chartered accountant should
be accepted
c. Past performance cannot be compared with projections and the difference taxed
d. Discounted Cash Flow method, which is allowed under law, is a valid method
2. Along with Merchant bankers, chartered accountants should be allowed to provide a
valuation report since the method remains the same, whereas the cost and availability of
professionals differs vastly between them
3. Any Company issued a scrutiny or tax notice now, for the reasons stated above, should have
their case reviewed by the same Assessing Officer and if the documents are found to be in
order, it should be closed
4. Any Companies who have received demand notices in the past should be allowed to contest
the demand without paying the 20% deposit required to contest it or have the money
refunded
5. A time-barred judgement on all such angel tax matters pending before the authorities, either
past or present, should be closed by March 31, 2019
6. Any issue about the creditworthiness or source of funds should first be verified against the
returns already filed by the investors and if there are pending inquiries, these should be taken
up directly with the Investor whose PAN has been provided by the Company. No roving
inquiries should be made against the Companies or investors.

9. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
Long Term Measures:
Link the MCA and CBDT databases via APIs so that the Startup India registration and capital
raise information filed with the MCA can be accessed by the CBDT:
Objective: Leverage existing public information to minimise friction
• All Companies who raise capital have to file the allotment forms with the details of the
capital raise with the Ministry of Corporate Affairs (MCA)
• This information should be shared with the CBDT so that they can assess the inevstors into
these Companies instead of burdening the Companies with the task of obtaining confidential
information from investors to gauge creditworthiness
Modify the Tax Return Form for Companies to accommodate the DIPP registration number
and details of the capital raises with the CBDT
Objective: Increase transparency of information and minimise friction
• A new form proposed (Annexure A) contains the salient details required to establish the
identity, creditworthiness and the source of Funds of the investors for their respective
investment into the Company
• The form is aligned with the requirement of the Company’s Act 2013 and Foreign Exchange
and Management Act, 1999 for any non-resident investors and includes a provision for the
PAN of the domestic investors and UIN of any non-resident investors.
Introduce the Accredited Investor concept and modify ITR-2 and ITR-2A to include a schedule
for such investments by Accredited Investors
Objective: Increase transparency of information and minimise friction
• From April 1, 2016, the CBDT has amended the Income Tax Forms for tax payers earning a
salary greater than Rs 50 lakhs to capture details of their assets and liabilities. This should be
further amended to capture details of the investments made into startups including the
premium paid
• This will also capture this information for posterity and clarify the investment details for any
exit from these investments
• This will form a self-contained system of checks & balances alogn with the details filed by the
Company obtained from the MCA
Modify Section 68 to allow the Assessing Officer to reach out to the Investors for any
information regarding the source of funds if this has not been declared in the investors’ tax
returns and filings
Objective:
• Section 68, which is linked to 56(2)(viib) directly, unduly placed a burden on the Company to
provide information about the Investor’s creditworthiness and source of funds. Investors are
hesitant to share these details, due to their sensitive nature, with the investee Company.
• The modification will ensure clarity of demonstration source of funds and remove the
Company as an unnecessary intermediary

10. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
Declaration that from the Company stating that the capital so raised has not been re-invested
into the Investor’s business or into any related party of the investor
Objective: Reduces possibility of malfeasance and creates evidence
• To address the issue that the funds raised by these Companies is being laundered, the
Companies can sign a declaration stating that the funds raised will be used for the business of
the Company and the same shall not be invested into an investor’s entity or into Company
belonging to a related party of the investor (Related Party defined as per the Income Tax Act,
1961 – Section 40A(2)
• The bank statement of the Company can be submitted as proof for the same, if requested by
the Assessing Officer
Conclusion:
The infographic below shows the scale achieved by Indian Startups over the past few years.
Figure 4 - Inc42 report (State of the Indian Startup Ecosystem), launched in November 2018
India’s quest to become a 10 Trillion Dollar economy by 2030, startups will play a crucial role as
engines of growth, job creators and creators of value. The government has rightly stated that it
intends to assist entreprenrues and startups on this journey and improve the ease of doing business
in India. With the right climate, these Companies can create tremendous value for India in terms of
wealth generation, employment and creation of intellectual property.
About the Author:
• This paper has been authored by Siddarth Pai, Policy Expert Council Members, iSPIRT
Foundation and Founding Partner at 3one4 Capital, an early stage SEBI registered Venture
Capital Fund based in Bangalore
• Inputs from Mr T.V. Mohandas Pai, Nakul Saxena of Ispirt, Sachin Taparia of Local Circles,
and Pranav Pai and Yash Kalro from 3one4 Capital.

11. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
Annexure A- Details to be added to the Income Tax Return of
Companies
Details of Shares Issued
Mode of Fund Raise (Private Placement, Rights Issue, Preferential Allotment)
Date of Fund raise
CTC of Board Resolution Approving
Fund Raise
Price per Share as per Valuation Report
(Attach a copy of the valuation report)
Investor Details
Name of
the
Investor
Structure of Investor
(Individual, HUF, Trust,
, company,
partnership, VC Fund,
others)
Date of
Receipt of
funds
Number of
Shares
Subscribed
To
Face
Value of
Shares
Premium
of Shares
Address
of
Investor
Email ID of
Investor
Residence
Status of
Investor
PAN
(Residents) /
UIN from
SMF/FCGPR
(Non –
Residents)
Mode of
Receipt of
Funds (Bank
transfer,cash)
• Attachments:
o Valuation report
o Copy of the return of allotment for the fund raise
o CTC of the Board resolution approving the fundraise
• Legend:
o HUF – Hindu Undivided Family
o VC Fund – Venture Capital Fund
o PAN – Permanent Account Number
o UIN – Unique Identity Number
o SMF – Single Master Form
Details of the Company and Contact Information
Name of the Company
Date of Incorporation / Registration of
the Company
Incorporation Number / Registration
Number
Registered Address
Permanent Account Number
Is the company registered with the DIPP
as a Start-Up
If Yes, Provide DIPP Number

12. White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India
Annexure B - Annual Form to be filed by any Accredited Investor or
Tax Payer investing into Private Limited Companies
Details of the Company and Contact Information
Name of the Investor
Accredited Investor Number (if
applicable)
Registered Address
Permanent Account Number
Registered
Name of
the
Company
CIN of the Company PAN of the
Company
Date of
transfer of
funds
Number of
Shares
Subscribed
To
Face
Value of
Shares
Premium
of Shares
Mode of
Receipt of
Funds (Bank
transfer,cash)