Is Dematerialisation Of Securities The First Step In Resolving Angel Tax Concerns Of Startups?

In a significant development, the Ministry Of Corporate Affairs (MCA) last week issued a notification mandating the dematerialisation of securities for unlisted companies.

The move is expected to benefit startups and is in line with the recommendations of industry experts highlighted in our previous covered on “What Startups Want? Settling The Angel Tax Debate Once & For All“. In the article, the experts proposed dematerialisation as a measure to address issues related to angel tax concerns. 

Under the new regulations, unlisted private companies, excluding small companies, are required to dematerialise their shares by September 2024.

The MCA notification states that every private company, except small companies, will now be required to issue securities solely in dematerialised form and must facilitate the dematerialisation of all of their securities. Private companies that don’t fall under the “small company” category, as of March 31, 2023, have an 18-month window, expiring in September 2024, to comply with these regulations. 

According to Harry Parikh, a partner at BDO India, the mandated demat rule is applicable to private companies, which have paid up capital exceeding INR 40 Mn or turnover exceeding INR 400 Mn. 

“The paid-up capital threshold is of a lesser issue for startups since there is a tendency to have higher valuations. Hence, startups tend to issue shares at a premium, which results in a lower paid-up capital base. Having said that, the threshold on the turnover is a tricky one and could pose a challenge to the startups because many startups are valued based on gross merchandise value,” Parikh said. 

As per the MCA notification, any company making offers for issuing securities, conducting buybacks, issuing bonus shares, or rights offerings after the compliance deadline must ensure the dematerialisation of the entire holdings of securities held by its promoters, directors, and key managerial personnel. Additionally, individuals holding securities of private companies are also required to have their shares dematerialised.

Commenting on the development, Siddarth Pai, the founding partner of 3one4 Capital, said that the dematerialisation of shares has been a long-standing demand for private companies. Startups, as they scale, often choose to dematerialise their shares as it simplifies shareholder management and facilitates faster exits. 

Pai noted that the move will bring transparency in ownership, and he now sees the streamlining of one of the most complicated tax regimes on the cards. Opaque holding structures within private companies have been cited as one of the reasons for the persistence of angel tax concerns, and this regulatory change is expected to address this issue, he added.

What Do The New Rules Say? 

Earlier, on October 2, 2018, Section 29 of the Companies Act, 2013, in conjunction with Rule 9A, of the Companies (Prospectus and Allotment of Securities) Rules, 2014 came into effect, which stipulated that every unlisted public company (barring a few like Nidhi, govt’s and subsidiaries) should issue securities only in dematerialised form and facilitate the dematerialisation of existing securities. However, this regulation did not encompass private companies at the time.

The latest notification, issued by the MCA on October 27, 2023, has introduced two significant amendments to the rules under the Companies Act, 2013 — the Companies (Management and Administration) Second Amendment Rules, 2013 and the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023. These amendments are aimed at enhancing transparency in the administration of corporate affairs.

Under the latest amendments, private companies are required to obtain International Securities Identification Numbers (ISINs) for all existing securities issued by them, facilitate the dematerialisation of all existing securities upon requests from security holders, and ensure that the complete holdings of their promoters, directors, and key managerial personnel are maintained in dematerialised form before making any offers for issuing or buying back securities on or after September 30, 2024.

The amended rules seek to eliminate bearer share warrants due to difficulties in tracing ownership, while share warrants issued to identified individuals following legal transfer procedures remain unaffected.

Will The New Rules Help Fight Angel Tax Demons? 

The Centre introduced the angel tax in 2012 to curb the flow of black money. The regulators have been facing difficulties in tracing the ultimate beneficiary for startup investments. 

The new amendments mandating dematerialisation are expected to help tax authorities identify the ultimate beneficial owners, according to CA Prerna Peshori, partner at Peshori Pachori & Jain. 

The amendments would be relevant in the case of the application of angel tax provisions for the company issuing shares at premium and invocation of Section 68, which relates to unexplained cash credit in the hands of the company. 

Section 68 seeks to tax the amount received on share application money or share capital or securities premium if the nature or source of such amount cannot be proved by the company as well as the resident shareholders who invested the funds. With the dematerialisation of shares, the tax department can trace and pursue the shareholders who try to invest unaccounted funds.

Recently, the Income Tax Department issued notices to startups, asking them to furnish the income tax returns (ITRs) of their shareholders for the past three years to ascertain if the investment made by such shareholders was commensurate with their income shown in tax returns. Many startups have raised concerns about this requirement as investors may not be willing to share their ITRs with the company. Peshori believes the amendments will solve this problem.

“With dematerialisation, the tax department would be able to trace the shareholding of the company without requiring the company to maintain the personal information of all the shareholders. Further, this can even be reconciled with the data submitted by the shareholders, who are required to report their shareholding in the unlisted companies in their ITR.

Like the share transfer of listed companies, which gets reported in the Annual Information Statement (AIS), a similar mandate can be created for share transfer of private or unlisted companies so that the tracking can easily be made by the tax department,” Peshori added.

As such, the latest amendment is expected to enhance the transparency of transactions in unlisted companies, marking a significant step forward in India’s regulatory landscape.