Now Tax Scare On the Corner For Startups With Marked Down Valuations

The funding climate is as such being touted heading towards winters with drying funds and falling valuations. Added to that scare now is the problem of tax authorities proposing a rather controversial move to levy tax on those startups whose valuations have been marked down on the grounds that the first premium was more than the firm’s fair value.

The proposal is being considered on the back of the Section 56 of the Income Tax Act which confers on the tax authorities the power to levy excess consideration, more than the fair value, against issue of shares. Section 56 (2) (vii) (b) of the Income Tax Act states:

“Any consideration received by a company (startup) from a resident, against issue of shares, exceeds the fair market value of such shares, such excess consideration is taxable in the hands of the startup, as an income.”

Now recently valuations of many startups have fallen on worries over profitability, growth and an intensely competitive environment. Tax officials believe that startups should be valued on the basis of the last round of investment. Hence as per them, considering the current slashed down valuations as the fair price of the company, the differential amount of the funds raised in earlier rounds at a higher valuation are taxable.

Additionally, this section exempts venture capital funds registered with Securities and Exchange Bureau of India (SEBI). Hence, it will affect only those startups that are funded by angels or funds not registered with SEBI. Consequently, as most of the rounds in these startups are made by angel investors basis faith and confidence in the team with valuations at that point being more a reflection of their faith rather than solely concrete metrics, this will affect these funding rounds as now the angel can be snapped with tax with down rounds becoming a widespread phenomena now.

Despite the industry’s long standing demand that the government should either do away with the angel tax or provide a monetary threshold for exemption for startups, this has not come to fruition. Instead what might come to pass is, angel investors seeing their prior investments which were done at higher valuations in startups, getting taxed under Section 56 of the Income-tax Act.

Countering Black Money But Also Impeding Investment?

While the Act’s purpose is to counter the inflow of black money being routed this way to convert to white, but what it could end up doing is making angel investors even more cautious about their investments, and thus affecting investor sentiment in an already sombre funding environment. Additionally, it will also make things more difficult for startups. They too will have to very careful with careful with valuations at initial stages, given that down rounds are becoming so common now and might even have to look for other methods of funding than equity, i.e., debt and debentures. But in the worst case scenario, they will have to bear additional tax or might have to shut down on account of non-payment of taxes due to fund crunch.

Another point to note is that in many startups, the first round of investment would have been made by an angel investor at valuation of 2x, while the second round could be at 2x or x or even 3x. Now the revenue department would calculate the fair value of the startup based on the PE’s investment, thus making the investment by only the angel taxable. Now with most startups facing this situation of down-round funding, their troubles will be exacerbated by this proposal.

Lastly, it will depend totally upon the discretion of the assessing officer’s assessment whether a startup is justifying its premium or not. The same clause defines fair value as-

For the purposes of this clause,—

(a) the fair market value of the shares shall be the value—

(i) as may be determined in accordance with such method as may be prescribed; or

(ii) as may be substantiated by the company to the satisfaction of 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 similar nature,

whichever is higher;

As it is well known, there is no prescribed measure to conclusively deduce valuations or premiums. Hence, it will be totally be the assessing officer’s privilege in deciding if a startup’s valuation is justified. Therefore, transparency is likely to go for a toss here, as scope of influencing his opinion will lead to illegal tactics. So while the law may try to curb one menace, it may end up giving rise to another.

Suhas Baliga, founder of Mumbai based law practice Innove Law, that works extensively with startups, stated,

“Most technology startups today are being valued by shareholders on markers that do not follow conventional valuation methodologies, under the garb of “discounted cash flow”. As such, it is as much guesswork as any other even in late stage heavily funded startups. Shareholders may take a view on valuation from time to time, but it beats my understanding how a change in valuation can be used to justify opening up a previous valuation given that they are being declared at different points of time, and the valuation may have changed in the meanwhile. Given the hocus pocus involved startup valuations generally (and complete lack of science), I think tax authorities are seeing the confusion and chaos as a good opportunity to make merry.”