In part 1 of this series, we discussed about history of security market in India, basic taxation provisions, recognition of shares & securities as stock-in-trade or capital asset, treatment on conversion of shares from capital asset into stock-in trade & income from derivatives. In this part of the series, we will delve further into intricate topics much sought after topic of Angel tax.

Angel tax – Section 56(2)(viib)

Section 56(2)(vii)(b), a section introduced vide Finance Act, 2012 intends to tax consideration received

1. for issue of the shares
2. from a resident or a non-resident (included investments received from non-residents amendment vide Finance Act, 2023
3. & where such consideration exceeds the FMV of the shares (subject to consideration exceeds the face value of the shares)

Such difference is taxed under the head Income from Other Sources in the hands of the company issuing such shares.

Since the insertion of this provision, there have been various representations that such provisions be deleted. However, these provisions remain to exist. However, these provisions came in light post the start-up saga that the nation witnessed where a mere idea was funded without considering the actual valuation in place for that company. During this period, section 56(2)(viib) affected a large number of such start-ups as the money raised by such companies was at a higher rate then the FMV. Thus, considering the hardships faces, the Government issued a notification dated 11th April, 2018 provided exemption to start-ups securing DIPP approval or approval from Inter-Ministerial Board of Certification.

Though, this was a welcoming step, the process of claiming such exemption was far more than easy as it requires various approvals & no specific timeline for such approval.

However, this tussle made DIPP to reach to the Department & vide notification dated 16th January, 2019, amended the approval process wherein now the approval had to be given by the CBDT & a timeline of 45 days was fixed to reject or approve the application. However, this too did not solve all the issues which made the Department to issue a fresh notification dated 19th February, 2019 cancelling all the previous notifications & it expanded the definition of the start-ups. It laid down that an entity shall be considered as a start-up:

1. Up to a period of ten years from its date of incorporation or registration, if it is incorporated as a private limited company, partnership firm or limited liability partnership firm.
2. The turnover of the entity for the any of the financial years since its incorporation has not exceeded INR 1,000 million.
3. If its work includes innovation, development or improvement of products, processes or services, or if it has a scalable business model with a high potential for employment generation or wealth creation.

Further, for claiming exemption under section 56(2)(viib) of the Act, the conditions are as under:

1. A company needs to be a recognised start-up according to the DPIIT’s notification.
2. The aggregate amount of paid-up share capital and share premium of the start- up after issue or proposed issue of share, if any, should not exceed INR 250 million rupees.

However, such recognised start-ups are limited & litigation is still prone to the assessee’s who get their valuation done which is still challenged. Thus, the assessees have a mammoth task of convincing the Department that the FMV that they have calculated is fair as the Department took the view that the value adopted is higher & the actual valuation has to be lower. Thus, the difference was brought under the tax purview.

Thus, the litigation mainly revolves around valuation which is given under rule 11UA which was recently amended vide Notification dated 25th September, 2023 whose features are as under:

1. The amended Rule 11UA provides separate valuation mechanism for compulsorily convertible preference shares (CCPS) and also provides an option to adopt fair market value (FMV) ofunquoted equity shares for determining FMV of CCPS.
2. The amended Rule 11UA provides separate valuation mechanism for compulsorily convertible preference shares (CCPS) and also provides an option to adopt fair market value (FMV) ofunquoted equity shares for determining FMV of CCPS.
3. The erstwhile Rule 11UA prescribed two methods (viz. NAV or DCF) for determining the FMV of equity shares issued to resident investors. The amended Rule 11UA provides five more methods of valuation for issue of unquoted equity shares or CCPS to NR investors viz. Comparable Company Multiple Method, Probability Weighted Expected Return Method,Option Pricing Method, Milestone Analysis Method and Replacement Cost Methods.
4. The price matching facility as per draft rules for both resident and NR investors is extended to CCPS. In terms of such price matching facility, the price at which unquoted equity shares or CCPS are issued by CHC to notified NR entities/ venture capital funds (VCF)/ specified funds shall be adopted as FMV for the purposes of benchmarking equity and CCPS investments by both resident and NR investors, subject to compliance of certain conditions.
5. In relation to price matching facility, price at which shares are issued to notified NR entities/ venture capital funds (VCF)/ specified funds shall be adopted as FMV, if receipt of consideration is within a window of 90 days before or after the date of issuance of shares subjected to valuation.
6. The erstwhile Rule 11UA required merchant banker DCF valuation report as on the date of issue of shares. The amended Rule 11UA provides flexibility by making valuation report issued up to 90 days prior to the date of issue of equity shares or CCPS for computing FMV for investments by both resident and NR investors.
7. Lastly, amended Rule 11UA introduces safe harbour limit of 10% for valuation of equity shares and CCPS for both resident and NR investments. The amended Rule 11UA provides separate valuation mechanism for compulsorily convertible preference shares (CCPS) and provides an option to adopt fair market value (FMV) of unquoted equity shares for determining FMV of CCPS.

Thus, the main issue revolves around is valuation to be accepted by the Department.

In view of the same, a few pertinent cases are as under:

No particular method can be imposed on the assessee however the revenue authorities can scrutinise the valuation report & suggest necessary alternations and modifications or even invite comment on its report by an expert– Jaipur Tribunal in the case of Rameshwaram Strong Glass (P) Ltd v. ITO (2018] 172 ITD 571 (Jaipur)(Trib.)

Similar ruling is given by Bombay High Court in the case of Vodafone M-Pesa Limited v PCIT 2018] 92 taxmann.com 73 / 256 Taxman 240 (Bom)(HC) where the Revenue authorities asked the taxpayer to consider actual figures for the intervening years between the date of its valuation report and the year in which the actual assessment took place. High Court while striking down the order held that DCF is based on estimations & can’t be compared with actuals

In this article of the series, we saw application of section 56(2)(viib) w.r.t start-ups. In the next article, we will analyse section 56 & its interplay with shares & securities along with taxation of ESOPs.