In this article, Agrima Tripathi, pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses on whether startups need IMB certification to avail angel tax exemption.

Introduction

India is the world’s third largest startup ecosystem, witnessing the emergence of 3-4 new startups everyday which makes it the fastest growing startup base. A startup not only fulfills the entrepreneurial dream but also provides employment to millions of people and contributing in the growth of the nation.

One such initiative to promote innovation and entrepreneurship is launched by Government of India as “Startup India”. It was launched on January 16, 2016 by the Hon’ble Prime Minister of India Shri Narendra Modi. The startup India Action Plan aims at “accelerating the spread of the Startup movement by: Simplification & Handholding, Funding Support & Incentives, Industry-Academia Partnership and Incubation.” Through the launch of Startup India, the Government of India has taken measures to improve the ease of doing business and create an enabling and exciting environment for these startups.

What is a Startup?

According to the Notification, an entity to be considered as a start up, the following conditions must be fulfilled. (See here)

1. The startup must have completed a period of seven years from the date of incorporation/registration. The duration is extended to ten years if the Startup is in the biotechnology sector.
2. The entity is registered/incorporated as a private limited company, as a partnership firm, or as a limited liability partnership.
3. The turnover for the entity for any of the financial years has not exceeded Rs 25 crore.
4. The Entity to be considered as a Startup should not only work towards bringing innovation, development or improvement of products or processes or services but also should generate employment or creation of wealth.

If an entity is formed by splitting up or rebuilding of an existing business then it shall not be considered a ‘Startup’.

When entity shall cease to be a Startup?

The entity will not be considered as a Startup in the below mentioned scenarios:

1. When an entity has completed seven years from the date of its registration/incorporation and ten years in case of startups in the biotechnology sector, or
2. If the turnover of the entity exceeds Rs. 25 crore for any of the previous year.

Inter-Ministerial Board (IMB)

The startups need to have Inter-Ministerial Board (IMB) certificate to avail tax benefits. The Department of Industrial Policy and Promotion (DIPP) created the Inter-Ministerial Board to validate startups for the tax related benefits. The Inter-Ministerial Board comprises of the following members:

• Additional Secretary, Department of Industrial Policy and Promotion, Convener
• Representative of Ministry of Corporate Affairs, Member
• Representative of Ministry of Electronics and Information Technology, Member
• Representative of Department of Biotechnology, Member
• Representative of Department of Science & Technology, Member
• Representative of Central Board of Direct Taxes, Member
• Representative of Reserve Bank of India, Member
• Representative of Securities and Exchange Board of India, Member

Types of tax exemptions to recognized Startups

The IMB validates Startups for the below mentioned two exemptions:-

Section 80-IAC of Income Tax Act, 1961

A Startup to be recognised by DIPP should fulfil the eligibility criterias to apply to the Inter-Ministerial Board. For exemption on the profits and gains from business the following conditions mentioned below must be fulfilled:

1. If the Startup is a private limited company or a limited liability partnership,
2. If the incorporation of the Startup is on or after 1st April 2016 but before 1st April 2021, and
3. If the products or services or processes are undifferentiated and have the potential for commercialization and significant incremental value for customers.

The tax exemption under Section 80-IAC is given for any three consecutive years out of seven years from the year of incorporation of startup.

Section 56 of Income Tax Act, 1961

A Startup recognized by DIPP being a private limited company shall be qualified to apply to the Inter-Ministerial Board to avail exemption from income tax on investments higher than fair market value made by angel investors provided the below mentioned conditions are fulfilled:

1. The aggregate amount of paid up share capital and share premium of the Startup after the proposed issue of shares does not exceed ten crore rupees,
2. The investor/proposed investor, who proposes to subscribe to the issue of shares of the Startup has:
   1. 1. the average returned income of  more than or equal to twenty-five lakh rupees but not less for the preceding three financial years; or
      2. the net worth of more than or equal to two crore rupees as on the last date of the preceding financial year, and
3. The Startup has got a report from a merchant banker stating the fair market value of shares.

Angel Tax

The Finance Minister Pranab Mukherjee announced the introduction of Angel tax to the Finance Budget of 2012. Taxation is the main barrier for many Startups and has forced many angel investors to wither away from providing financial support to the entrepreneurial dreams.

Section 56(2)(viib) of the Income Tax Act, 1961, or the Angel Tax was inserted by the Finance Act, 2012 to tax any capital raised by a closely held company which is above its Fair Market Value (FMV) as income from other sources, with Rule 11UA(2) stipulating  ways for determining the Fair Market Value.

The Startups which have a total investment including investments from angel investors not exceeding Rs 10 crore can seek for approval from the Inter-Ministerial Board (IMB) for exempting them from tax under Section 56 of the Income Tax Act, 1961.

The two methods to determine the Fair Market value under Rule 11UA (2) are as follows:

1. Net Asset Value Method
2. Discounted Free Cash flow Method

According to Section 56(2) (viib) of the Income tax Act, 1961 the Fair Market Value of the shares shall be:

1. (i) The value as determined according to the method described under (Rule 11UA(2));

             Or

1. (ii) The value as may be authenticated by the company which satisfy 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 like nature. Whichever is higher.

Analysing Section 56(2) (viib) of the Income tax Act, 1961

The reason why Angel tax causes threat to startups and investors is because it gives major discretionary powers in the hands of Assessing Officer. There are multiple reported incidents where entrepreneurs are bogged down by the questions of IT officials over the valuation of funding. While the intention is to curtail money laundering and check undisclosed income, the government, in its eagerness is likely to do more harm than good.

One Such incident why Startups and investors are praying for respite from Angel Tax is narrated below:

Aditya (Name changed) is a Bengaluru-based entrepreneur. He was asked to provide further details of the angel investments that he raised in the year 2014-2015. The funding raised by Aditya was Rs 1.5 crore but the Assessing Officer considered only Rs. 1 crore as an investment and the rest Rs 50 lakhs was considered as an income on which Aditya would have to pay 30% tax. An appeal can be made against this within 30 days of passing of an order. However, the founders would have to pay 20% of the fine for filing the appeal. Many entrepreneurs does not have this money in hand.

Section 68 of the Income tax Act, 1961- Added Fear

Section 68 of the Income Tax, 1961 states that if any sum is found credited in the books of an assessee which is maintained for any previous year, and the assessee gives no reason about the nature and source of the money or the reasoning offered by him is not reasonable in the opinion of Assessing Officer, the sum which is credited in the books of assessee may be charged as the income of the assessee for that previous year:

However, where the assessee is a company (not a company in which the public are substantially interested), the sum so credited consists of share application money, share capital, share premium or any such amount by whatever name called, any reasoning given by the assessee-company shall not be considered as satisfactory, unless —

1. The person, who being a resident offers a valid justification as to the nature and source of the sum  so credited in his name in the books of such company records; and
2. The Assessing officer finds the explanation mentioned above to be satisfactory.

Section 68 further states that nothing contained in the first proviso will apply to the person, if the sum credited in his name recorded therein, is a venture capital fund or a venture capital company as referred to in clause (23FB) of section 10.

Many startups, who have surpassed the blade of section 56(2)(viib), also have to deal with section 68, which again gives discretionary powers in the hands of the Assessing Officer in addition to the powers already conferred by  section 56(2)(viib).

Remedies Imposed

The government has taken certain measures to promote and foster the Startup environment in India. The Central Board of Direct taxes (CBDT) on 14th June,2016 has released a notification stating that a company registered as a “Startup” which is also recognized by the Department of Industrial Policy & Planning (DIPP), any amount raised from an Indian tax resident will be outside the scope of section 56(2)(viib).

Conclusion

The initiative taken by the Government of India is praiseworthy but it also needs to understand the ground realities and hardships the entrepreneur has to face in achieving his/her entrepreneurial dream.

The government should take measures to encourage domestic investors to financially aid the Startups rather than penalizing them. The tax authorities should not be able to demand justification if the valuation is based on prospective information and the Startup has a valid valuation report, which is in accordance with the law. Startups are a good way to generate employment and also fulfill the entrepreneurial dream.