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Angel Tax Presentation To DIPP [Section 56(2)(viib)]

Key Issue Plaguing Startups And Indian Investors Recommendations

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Section 56(2)(viib): KEY ISSUE
PLAGUING STARTUPS AND INDIAN
INVESTORS AND
RECOMMENDATIONS
By T.V.Mohandas Pai, Siddarth, Nakul
Ispirt
Overview
2
▪ Overview of the Indian Startup ecosystem
▪ Section 56(2)(viib)
▪ Current issues facing startups
▪ Analysis of high premia amongst Indian startups and orders
received
▪ Effect on domestic investors and investments
▪ Practices in other countries
▪ Measures for aggrieved companies:
 Short term
 Long Term
▪ Annexures
Section 56(2)(viib)
3
Section 56(2)(viib)
4
Section 56(2)(viib)
▪ Introduced in 2012 by the UPA Government
▪ Issued under “Measures to prevent generation and
circulation of unaccounted money”
▪ Taxes as income any capital receipt in “excess” of the
fair market value of the securities issued by a private
company (Annexure 1)
▪ Has become an “angel tax” on capital raised by
startups only from Indian domestic investors, not
foreign investors
▪ No other country discriminates against domestic
investors in this fashion 5
Current issues facing startups
▪ Unfairly attacking high share premium of startups and private
companies and taxing the difference between book value and
the DCF projections as income
▪ High share premium cannot be the basis as its an outcome of
valuation, not the cause for high valuations
▪ Issue Price = Enterprise Valuation/No of shares issued
▪ Issue Price consists of: Face Value + Share premium
▪ Thus a small issued share base and low face value result in a
high share premium
▪ Stated motive of taxing unaccounted funds coming in as
premium has been replaced by indiscriminately taxing all
premiums!
6

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Angel Tax Presentation To DIPP [Section 56(2)(viib)]

  • 1. iSPIRT – Indian Software Product Industry Round Table is a non-profit think tank formed by leading practitioners of the industry to assist in the cause of building a healthy, globally-competitive and sustainable industry. Visit www.ispirt.in for more details. Section 56(2)(viib): KEY ISSUE PLAGUING STARTUPS AND INDIAN INVESTORS AND RECOMMENDATIONS By T.V.Mohandas Pai, Siddarth, Nakul Ispirt
  • 2. Overview 2 ▪ Overview of the Indian Startup ecosystem ▪ Section 56(2)(viib) ▪ Current issues facing startups ▪ Analysis of high premia amongst Indian startups and orders received ▪ Effect on domestic investors and investments ▪ Practices in other countries ▪ Measures for aggrieved companies:  Short term  Long Term ▪ Annexures
  • 5. Section 56(2)(viib) ▪ Introduced in 2012 by the UPA Government ▪ Issued under “Measures to prevent generation and circulation of unaccounted money” ▪ Taxes as income any capital receipt in “excess” of the fair market value of the securities issued by a private company (Annexure 1) ▪ Has become an “angel tax” on capital raised by startups only from Indian domestic investors, not foreign investors ▪ No other country discriminates against domestic investors in this fashion 5
  • 6. Current issues facing startups ▪ Unfairly attacking high share premium of startups and private companies and taxing the difference between book value and the DCF projections as income ▪ High share premium cannot be the basis as its an outcome of valuation, not the cause for high valuations ▪ Issue Price = Enterprise Valuation/No of shares issued ▪ Issue Price consists of: Face Value + Share premium ▪ Thus a small issued share base and low face value result in a high share premium ▪ Stated motive of taxing unaccounted funds coming in as premium has been replaced by indiscriminately taxing all premiums! 6
  • 7. Reason for high share premia amongst startups ▪ Pvt Ltd companies don’t have a minimum share capital requirement any longer (Companies (Amendment Act) 2015) ▪ Thus entrepreneurs start companies with a small issued capital and look to raise funding at the earliest in order to scale their business ▪ Most entrepreneurs start companies with an issued capital of 10,000 shares of Rs 10 each ▪ Thus even a valuation of Rs 10 Cr (1.43 Million $) will yield a premium of Rs 9,990!* Thus a high share premium is a natural outcome of valuation, not the cause of valuations 7 * Share issue price = Enterprise valuation/no of shares issued = 10Cr/10,000 shares = Rs 10,000 Issue Price consists of Face Value + Share Premium FV = Rs 10, thus Premium = Rs 9,990)
  • 8. Analysis of Notices and Orders In the 60 scrutiny notices and assessments orders analysed by Ispirt, the most common issues are: ▪ Valuation report submitted by the startup were disregarded ▪ Valuations done by the AO using a different method (Book Value) instead of the chosen Discounted Cash Flow method, resulting in a manufactured difference between the issue price and FMV ▪ Book Value is not appropriate as it’s the present value of the assets while DCF looks at the future earning potential – both have different approaches and significance and usage cases. ▪ Investors look at future earnings, not current assets. Most startups also have an asset-light business model. ▪ Stated budget measure of unaccounted funds is ignored as the nature or source of funds not examined, only the premia is taxed as income! 8
  • 9. 9 Effect on Domestic Investments
  • 10. Indian startups have the lowest valuations worldwide! 10 Silicon Valley Europe Israel India Source: Angellist - https://angel.co/valuations
  • 11. Domestic early Investments decline while other investments rise 11 Nasscom report – Indian Startup ecosystem Approaching Escape Velocity – Edition 2018
  • 12. No of Early stage rounds is down 28.5% INVESTMENTS IN START-UPS BY ROUND Year Seed Series A Series B Series C Series D Series E+ 2014 91 145 56 28 11 10 2015 208 257 93 41 12 11 2016 198 186 102 45 20 11 2017 174 154 101 30 21 15 2018 148 137 83 62 24 15 12 Source: Venture Intelligence
  • 13. No. of unique domestic investors down 48% since 2015 13 Inc 42 – State of the Indian Startup ecosystem - 2018
  • 15. Practises in other countries ▪ No other country discriminates against domestic investors investing into startups ▪ “Angel Tax”, or a tax on investments by domestic investors, is not taxed anywhere else in the world ▪ Instead of taxing such receipts, startup investments are incentivised:  UK - Seed Enterprise Investment Scheme (SEIS)  US – Section 1202  Singapore – Angel Investment Tax Deduction Scheme (AITD Scheme) ▪ No concept of valuation for startup investments, only exits and transfers ▪ High share premia is an outcome of valuation and has not been flagged as an issue of concern anywhere else in the world ▪ Prevention of unaccounted funds coming into startups is solved by:  Accredited Investor concept  Stringent AML and KYC  Bank transfers for all investments 15
  • 16. Accredited Investor - Introduction ▪ Accredited Investor is a means to ascertain sophisticated investors ▪ Only such investors can invest in risky asset classes like startups, venture capital funds, hedge funds, etc ▪ Self certified on the basis of minimum net worth or income criteria ▪ Investor protection measures like registration of securities, etc not applicable to them 16
  • 17. Accredited Investor - Criteria Criteria USA Singapore UK Net Worth USD 1 Million SGD 2 million GBP 250,000 Income USD 200,000 SGD 300,000 GBP 100,000 17 ▪ Other criteria include compliance with AML regulation KYC, FATCA, CRS, UBO (Annexure 2) ▪ All investments via bank transfers ▪ Declaration stating that the investor understands the risks of investing in such assets is also procured ▪ AML: Anti Money Laundering ▪ KYC: Know your Customer ▪ FATCA: Foreign Account Tax Compliance Act ▪ CRS: Common Reporting Standard ▪ UBO: Ultinate beneficial ownership
  • 18. Valuation Reports Worldwide ▪ Valuation reports for investments into startups are not mandatory or applicable in startup ecosystems across the world ▪ Even valuation expert Aswath Damodaran stated that the “absence of operating history” and that most startups “do not make it through these early stages to success” make valuations difficult ▪ Valuation reports only applicable during exits or transfers 18
  • 20. Types of cases afflicting Indian entrepreneurs Short Term: ▪ Private limited companies who have received assessments orders in the past and are appealing it ▪ Private limited companies who have received assessments orders in 2018 and are going to appeal Long Term: ▪ Companies who have raised capital recently and are liable to notices under this section 20
  • 22. 1. Companies who have received “angel tax” assessment orders in previous years or 2018 and have filed/going to file an appeal CBDT circular to be issued stating the following:  Initial deposit of 20% to obtain a stay to be waived  No coercive measures or deposits for appealing the orders  Valid valuation reports to be accepted and not disregarded/compared with performance/no change in valuation methods  If a SEBI registered VC Fund has invested at the same valuation, the case should be dropped  PAN of all investors to be filed by January 30th, 2019 and other details in the proposed format (Annexure 3)  Time barred closure of assessment by March 31st, 2019 Draft circular attached in Annexure 4 22
  • 24. Repeal section 56(2)(viib) and the link between section 68 and section 56(2)(viib) 24
  • 25. OR 1. In the upcoming budget, the following modifications to section 56(2)(viib) and section 68 to be added: 1. Investments received by a private company from resident investors upto Rs 10Cr per year to be exempt from section 56(2)(viib) and 68 as a class of people notified by the Central Government 2. For investments above 10Cr into private companies, Accredited Investors’ investments should be exempt from section 56(2)(viib) and section 68 along the lines 3. If an investment is made by a SEBI registered VC Fund, section 56(2)(viib) should not apply for that capital raise 2. Valuation report for investments by accredited investor and VC funds not applicable 3. Valuation reports prepared by Approved Valuers under the Company’s Act, 2013 cannot be disregarded 4. Link between exemption under section 56(2)(viib) and 80-IAC to be separated so that section 56(2)(viib) exemption can apply to a larger number of startups* 5. Committee formed by DIPP to review all open cases and give approvals as required to settle the matter beyond doubt 25 *Section 56(2)(viib) exemption only applies to “eligible startups” defined as startups incorporated after April 1, 2016 and registered with the DIPP and in receipt of the IMB approval. But the startups facing the angel tax issue is for AY 16-17, ie, FY 15-16 and were incorporated prior to April 1, 2016
  • 26. DIPP Committee ▪ DIPP proposed a committee of academics to assess the process of valuation & fundraising of startups ▪ This should have industry representation from prominent domestic investors  These domestic to recuse themselves for any investments in which they are interested ▪ Due to large numbers, best to look at the broad parameters of the process of getting the valuation report, theme of the startup ▪ For all startups undergoing appeals or those who have assessments orders should be the first applicants to this committee ▪ The recommendations of this committee should be accepted by the CBDT ▪ We request that the committee not evaluate these companies with the benefit of hindsight and compare performance to projections 26
  • 27. Accredited Investor ▪ Accredited Investor to be introduced bearing:  Gross Total income above Rs 25 lakhs for the past 3 years, or  Net Worth of Rs 1 Crore or  At least 25% of assets in financial investments ▪ Norms can be laid by DIPP/SEBI/FinMin and applicable for all investments ▪ All Accredited Investors can register with NSDL/CDSL/any authorised depository ▪ A declaration to the same should be self attested and a report certified by a chartered accountant, along with the PAN, should be submitted ▪ Accredited investor registration to be done along the lines of investments into AIFs or Mutual Funds:  KYC/FATCA/CRS/UBO information to be filed 27
  • 28. Accredited Investor ▪ The budget 2012 memo stated that the newly introduced measures would not apply when the “shareholder is a well regulated entity, ie, a VC Fund registered with SEBI” ▪ Thus for Accredited Investor, regulated by SEBI, section 56(2)(viib) should not apply and a Central Government notification classifying Accredited Investors as a class of persons to whom section 56(2)(viib) and section 68 should not apply. 28
  • 29. Conclusion ▪ Domestic funding is only 10% of all capital raised by Indian startups ▪ 56(2)(viib) was added to prevent laundering of unaccounted funds, but after the other stringent measures released (Annexure 5), it has now come to represent a draconian measure used to harass startups ▪ Measures like the angel tax are causing Indian entrepreneurs to incorporate businesses in Singapore/USA to operate in India ▪ Domestic investors need to be incentivised otherwise India risks becoming a digital colony 29
  • 30. 30 - Honourable Prime Minister Narendra Modi
  • 31. 31 Thank you for being part of this movement! Special thanks to: S Krishnan Harish HV & 3one4 Capital
  • 33. Anx 1: Bare Act: ▪ 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  (ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf. 33
  • 34. Anx 1: Bare Act: ▪ 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 prescribed 9; 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; 34 9 Rule 11ua(2) prescribes Book Value method or Discounted Cash Flow method, given by a Category I Merchant Banker or a chartered accountant (removed from April 1, 2018)
  • 35. Anx 2.a: Singapore: Accredited Investor In Singapore, Accredited Investor is defined in Section 4A(1)(a) of the Securities and Futures Act (SFA), Chapter 289: ▪ Net Personal assets exceeding SGD 2 million (or equivalent in foreign currency). Or ▪ Income in preceding 12 months of not less than SGD 300,000 (or equivalent in foreign currency). Or ▪ A corporation with net assets exceeding $10 million in value (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe, in place of the first amount, as determined by — (A)the most recent audited balance- sheet of the corporation; or (B)where the corporation is not required to prepare audited accounts regularly, a balance-sheet of the corporation certified by the corporation as giving a true and fair view of the state of affairs of the corporation as of the date of the balance-sheet, which date shall be within the preceding 12 months; ▪ The trustee of such trust as the Authority may prescribe, when acting in that capacity; or ▪ Such other person as the Authority may prescribe 35
  • 36. Anx 2.b: United States of America : Accredited Investor In the United States, to be considered an accredited investor, one must have a net worth of at least $1,000,000, excluding the value of one's primary residence, or have income at least $200,000 each year for the last two years (or $300,000 combined income if married) and have the expectation to make the same amount this year. The term "accredited investor" is defined in Rule 501 of Regulation D of the U.S. Securities and Exchange Commission (SEC) as: ▪ a bank, insurance company, registered investment company, business development company, or small business investment company; ▪ an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million; ▪ a charitable organization, corporation, or partnership with assets exceeding $5 million; 36
  • 37. Anx 2.b: United States of America : Accredited Investor ▪ a director, executive officer, or general partner of the company selling the securities; ▪ a business in which all the equity owners are accredited investors; ▪ a natural person who has individual net worth, or joint net worth with the person's spouse, that exceeds $1 million at the time of the purchase, or has assets under management of $1 million or above, excluding the value of the individual's primary residence; ▪ a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or ▪ a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes 37
  • 38. Anx 2.c: European Union : Accredited Investor Retail clients requesting treatment as 'elective' professional clients (as defined by Markets in Financial Instruments Directive (MiFID)) must satisfy at least two of the following quantitative criteria in assessing the client's expertise, experience and knowledge: ▪ the client has carried out trade transactions, in significant size (at least EUR 50,000), on the relevant market at an average frequency of 10 per quarter over the previous four quarters; ▪ the size of the client's financial instrument portfolio, defined as including cash deposits and financial instruments, exceeds EUR 500,000; ▪ the client works or has worked in the financial sector for at least one year in a professional position which requires knowledge of the transactions or services envisage 38
  • 39. Anx 3:Format of submission by startups 39 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)
  • 40. Anx 4: Draft Circular 40 MINISTRY OF FINANCE (Department of Revenue) (Central Board of Direct Taxes) NOTIFICATION New Delhi, the date xxxx 2019 INCOME-TAX S.O. XXXX(E).—In exercise of the powers conferred by the clause (ii) of the proviso to clause (viib) of subsection (2) of section 56 of the Income-tax Act, 1961 (43 of 1961) and in supersession of the notification number S.O.2088(E) dated 24th May, 2018 issued by Department of Revenue, Central Board of Direct Taxes, the Central Government, hereby notifies that the provisions of clause (viib) of sub-section (2) of section 56 of the said Act shall not apply to 1. the consideration received by all Startups recognised by the Department of Industrial Policy and Promotion as a Startup. 2. consideration received by all other companies: (i) if they are proposing to issue securities to investors having an average income of Rs. 25 lakhs or more for the preceding three financial years (as per filed income-tax returns), and net worth of Rs. 2 crores or more as on the last date of the preceding financial year, and (ii) has obtained a report from a merchant banker or a chartered accountant specifying the fair market value of shares in accordance with Rule 11UA(2) of the Income-tax Rules, 1962. Other companies would refer to companies who are not recognised as a Startup by the Department of Industrial Policy and Promotion but having a turnover of less than Rs. 25 crores for any of the financial years since incorporation/ registration upto a period of seven years from the date of incorporation/ registration and who have issued shares at a premium during this tenure. In the case of companies in the biotechnology sector, the period shall be upto ten years from the date of its incorporation/ registration. It is hereby clarified that the Fair Market Value certified by the merchant banker shall be accepted by the income tax authorities as a true and fair valuation. 2. This notification shall be deemed to have come into force retrospectively from the 17th February, 2016. [Notification No. xxxxx] XXXXXX, Director (Tax Policy and Legislation)
  • 41. Anx 5:Company’s Act Measures for plugging unaccounted funds ▪ All capital raised by a company needs to come in via bank transfers, with the bank account from which the investment is made being intimated to the company (Rule 14, Companies (Prospectus and Allotment of Securities) Rules,2014) ▪ Private placement and preferential allotment forms need to name the investor and such forms cannot be transferred to anyone else (Rule 14, Companies (Prospectus and Allotment of Securities) Rules,2014) ▪ PAN of the investors needs to be mandatorily filed with the Company (Rule 14, Companies (Prospectus and Allotment of Securities) Rules,2014) ▪ All raise documents need to be filed with the RoC for the raise to be valid ▪ Beneficial ownership to be declared within 30 days of an investment (Companies (Significant Beneficial Owners) Rules, 2018) 41