It was recently reported by many news agencies that the Income Tax department is in discussions about levying taxes on startups that have witnessed a down-round valuation. According to reports, this tax would be levied on the premium received by the company during the first round. The department here is of the opinion that the premium received by the company then was more than its fair market value (FMV).
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Background of this tax
Contrary to popular misconception, this is not a new tax that is being levied. The root of this tax lies in Section 56 of the Income Tax Act, 1961, which empowers the department to levy taxes on excess consideration received, more than the fair value of the shares issued for any tax to be levied. The fair value again for a private limited company is the value that is arrived upon as per the Discounted Cash Flow (DCF) technique.
Our opinion

The whole point of Section 56 is to curb black money. This section was enacted to stop unscrupulous practices, like misusing the route of paying premium for converting unaccounted black money to white money. How far this proposed move will help in meeting that end goal is debatable. Section 56 in itself has certain provisions that will turn out to be gaping loopholes if this tax is levied.

This section exempts venture capital funds registered with Securities and Exchange Bureau of India (SEBI). Hence, this Act, by default, gives immunity to startups that are funded by venture funds. Even after repeated requisitions, angels were not insulated from these provisions. Hence, it will effect only those startups that are funded by angels or funds not registered with SEBI.

Generally, the first investment round in a startup comes from angels. The valuation can be anything like three or two times. The VC again would value the company, which may be equal, lower or more than the earlier rounds. The startup is still new and in the growth phase.

Hence, these valuations are more inclined towards faith and team of founders. It would not be wrong to say that valuation at this stage is mere opinion, less concrete on figures and metrics, and based on projections. However, a private equity (PE) investor will definitely come at a lower valuation. A PE usually comes on board after a longer period, say 7-8 years.

Now, by the virtue of this tax, the fair value would be calculated based on the PE’s investment, thus making the investment by only the angel taxable. It would be assumed that the company has not issued shares at FMV and the premium would be taxable at straight 30 percent. Besides, the same thing would be done for every round of funding received at a premium, with an interest rate of 12 percent for delayed payments.

The irony is that recently almost all startups are facing this situation of down-round funding. Not even unicorns like Flipkart and Snapdeal are immune to this. These unicorns and the likes of them, however, are not going to be impacted by the levy of this tax as they are funded by VC investments.

So, in all, this tax is going to impact those startups that are already struggling; otherwise a super growing startup will always raise funds at a higher valuation vis-à-vis earlier rounds.

Considering the same, I do not find it logical or even feasible to levy taxes on them. The resultant outcome can only be two. Shutting down of the startup either on account of non-payment of taxes due to fund crunch, or on account of over expenditure of funds to pay the tax such that it doesn’t have enough liquidity to meet its operational requirement.

From the industry pointy of view as well, this does not serve any purpose. First, the administrative expenses of the department for litigation and collection of taxes would never match the actual taxes ought to be collected.
Secondly, this is going to be a serious deterrent in startups getting funded, since naturally the angels would be apprehensive in investing one. Lastly, there is no prescribed measure to admit the valuation/premium debate. It is totally upon the discretion of the assessing officer whether a startup is justifying its premium or not, no matter what the valuation reports say. Hence, there is no transparency and is likely to give room for illicit activities.
To conclude, I feel that this move, if adopted by the department, is not likely to achieve any rational outcome. I only hope that the proposed provision never sees the daylight. Let better sense prevail.