A founder who is in the middle of raising a down round said the threat of getting I-T notices has gone up especially after the government brought overseas funds under ‘angel tax’, or Section 56(2)(viib) of the Income-Tax Act, 1961, from 2023-24.
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Until 2022-23, the angel tax provision was applicable only upon issuance of shares to tax residents in India. The Finance Act 2023 has expanded its scope to include the issuance of shares to tax non-residents in India.
Tax sleuths have in recent times issued notices to specific startups, seeking information on investor creditworthiness and verifying if investment amounts align with declared incomes.
After the IT department action, entrepreneurs whose companies have experienced significant value losses in the past year or so are growing increasingly concerned about the possibility of receiving notices from assessing officers as their ventures have seen substantial fluctuations in valuations within a relatively short timeframe.
These startups had previously raised funds from venture capital (VC) and private equity (PE) funds at a premium, based on ambitious forecasts projected a few years ago. But now the valuations of high-profile startups like Byju’s, Dunzo and Pharmeasy among many others have plummeted.
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The fear in the industry is that the department will not only scrutinise the lofty valuations made earlier but could also demand additional taxation under the angel tax provisions.“Startups and new-age companies have fluctuating valuations, making the angel tax a contentious issue in many transactions,” said Girish Vanvari, cofounder of tax and regulatory advisory Transaction Square.
“Though litigations happened in the past, the judicial precedents have been that as long as the valuations are reasoned and backed by evidence, companies have got relief,” he said. “However, now, with the extension of the scope of angel tax in the last budget and several deep downgrading of companies, it will be interesting to see how things pan out.”
Downgrades will put more stress on past valuations and more scrutiny, Vanvari said. “However, if the valuations are rightly done, the companies should be protected,” he added.
ETtechAs per the tax laws, if an Indian company issues new shares at a price exceeding the fair market value, the excess premium is considered income for the company.
Tax experts said valuations had taken place 3-4 years back based on projected revenues and profits but now tax department can compare projections with actual sales that happened during the time period.
“The real challenge doesn’t stem from the down round itself, but rather from the previous upper rounds conducted during the high market rallies,” said Tushar Sachdev, tax partner at PwC. “However, the current concern could indeed be triggered by the fact that a down round is now happening.”
According to him, the crux of the matter lies in ensuring accurate valuation.
“The debate doesn’t revolve around transactions occurring at unfair values. Instead, the focus is on the methods used for valuation,” Sachdev said. “Valuation is considered more of an art than a science. The challenge arises because tax officers typically assess these transactions two to three years after they’ve occurred. During this time, they analyse the situation in the context of what has transpired.”
Tax experts pointed out that while valuations had taken place 3-4 years back based on projected revenues and profits, now the tax department can compare projections with actual sales that happened during the time period.
A major problem for startups is that, as per the new provisions, certain entities, such as category 1 foreign portfolio investors, endowment funds, pension funds, and broad-based funds established in important jurisdictions like Singapore, the UAE, Mauritius, and certain European countries like Ireland and the Netherlands, which are common sources of investments, are not exempt from the rule.
Experts said this restriction rendered the exemption almost meaningless because of the jurisdictional condition.