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Startups that raised funds from angel investors face tax scrutiny
February, 20th 2018

The so-called angel tax may not be quite dead yet. Although the income tax department has been instructed not to harass startups unduly, those that raised funds from angel investors through rights offers rather than via private placements in the past few years are coming under scrutiny along with their investors, said people aware of the matter.

Tax officials have started questioning some startups on their fundraising methods.

While notices haven’t been issued yet, that could change, said the people cited above. Some startups had opted for rights offers because of the complexities involved in the private placement method, they said. “Under the Companies Act, private placement is a cumbersome process when compared to a rights issue and several startups had opted for the latter,” said Amit Maheshwari, partner, Ashok Maheshwary & Associates LLP. “After the rights issue, the existing investors in startups had renounced rights in favour of the new investors. This could potentially have tax impact in the hands of the investors.”

The tax department could levy tax after calculating the quantum of benefits in the hands of the new investors and even for the startups, said tax experts.

The angel tax applied to investments made at a premium to the ‘fair’ value. The difference was considered to be income and deemed taxable under Section 56 of the Income Tax Act. However, the government issued clarifications in 2016 and again this year aimed at exempting investments by Indian residents in entities that were certified as ‘innovative’ startups in order to encourage entrepreneurship and boost job generation.

While a rights issue is typically at lower valuations, many startups have seen down rounds or substantial drops in valuations since the funding. Looking back, the rights issue was made at a valuation in excess of fair value. The tax department could once again trigger Section 56, experts said.

“If a company issues shares at a premium more than fair market value, then the differential is taxable in hands of the company,” said Amit Singhania, partner at law firm Shardul Amarchand Mangaldass.

“This becomes more apparent if the valuation of a company significantly goes down (subsequent to issue of share) in a short period of time. In such circumstances, it appears that the shares were previously issued at significantly higher premium.”

While restrictions were introduced three years ago on fund raising through rights issues in the Companies Act, many startups opted for the route as the government had not issued any explicit directive against it, experts said. A Bengaluru startup that’s a marketplace for high-end shoes is one of those that’s approached lawyers for advice on the matter.

“Since the corporate affairs ministry has not raised any objection in the last three years, this is taken as consent by many startups. Most startups have been raising funds through rights issue now,” said a lawyer aware of the matter.

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