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How Can We Stop Section 68 From Becoming The New “Angel Tax”

How Can We Stop Section 68 From Becoming The New “Angel Tax”

The new notification has lifted the spirits of Indian entrepreneurs around the dreaded “Angel Tax” — section 56(2)(viib)

Section 68 is older than section 56(2)(viib) and exists on the statute books to delve deeper into fraudulent transactions

For startups dealing with a notice under Section 68 — do not become a middleman between the AO and your investors

The recent DPIIT circular and tweetstorm by Suresh Prabhu has done wonder to lift the spirits of Indian entrepreneurs around the dreaded “Angel Tax” – section 56(2)(viib) of the Income Tax Act, 1961. Inserted by the UPA government in 2012, this statute was meant to prevent the laundering of unaccounted funds as high share premium through private limited companies, but began to be misapplied to startups who raise capital from Indian investors.

Much has been written about this draconian measure – about how it discriminates against Indian investors in India, how no other country in the world attacks share premium in this fashion as it’s the outcome of the maths surrounding valuation.

But during this time, a greater danger under Section 68 has reared its head (link). This has not received as much publicity as section 56(2)(viib), but this is the more pernicious of the two sections. The recent cases of TravelKhana and BabyGoGo, who have seen their bank accounts emptied because of Section 68 has sent shivers through the entire Indian startup ecosystem.

Section 68 is older than section 56(2)(viib) and exists on the statute books to delve deeper into fraudulent transactions. Unlike 56(2)(viib), it is unconcerned with valuation or premium and instead seeks to establish three facets of each investor:

  • Identity
  • Creditworthiness
  • Genuineness of transactions

But the means of achieving this, due to various judicial pronouncements, places significantly higher rigour on private companies as opposed to public companies. The 2012 Budget Memo, which saw the introduction of Section 56(2)(viib), also highlights this:

The Courts have drawn a distinction and emphasised that in case of private placement of shares the legal regime should be different from that which is followed in case of a company seeking share capital from the public at large.

The principle underpinning this is further elaborated in the same memo:

“In the case of closely held companies, investments are made by known persons. Therefore, a higher onus is required to be placed on such companies besides the general onus to establish identity and credit-worthiness of creditor and genuineness of transaction”

The assumption that private companies require investments to be made by known persons of such intimacy that the creditworthiness can be established is farfetched in this day and age as startups raise money from various HNIs, Family Offices, etc who view such transactions as commercial ones and conducted at an arm’s length.

In light of this, the CBDT had issued a Standard Operating Procedure note on Section 68 which sheds light on the judicial pronouncements around this section and the principles that guide the Assessing Officers (AOs) while investigating this. What is evident from this SOP is that the following documents will be required to prove the 3 criteria stated above:

  • Copies of the Income Tax Returns of the investor
  • Copies of the Bank statement to show that the transaction was made from the stated account
  • Financial Statements of the investor, if applicable – to demonstrate that they have the financial ability to make such an investment

So, This Begs The Question: Will Section 68 Become The New Angel Tax?

Section 68 differs from 56(2)(viib) as it doesn’t question something as abstract as valuation or “high” share premium, it instead looks at the source of funds to establish if it’s bonafide or not. In the absence of stricter regulation of investors into private companies, along the lines of SEBI registered VC Funds, this section will not be removed from the statute books.

A look at the case law around Section 68 also attests to this as a variety of cases have been ruled in favour of the tax department, unlike section 56(2)(viib). Until such regulation such as that for “accredited investors” a method of establishing the bonafide details of an investor to ensure that such investments do not become a conduit for laundering unaccounted funds, a startup can protect themselves through the following measures.

Seek money from genuine and trustworthy sources:

The 2012 Budget memo lays out the degree of verification required from a private company before they can accept any money from investors

“This additional onus, needs to be placed on such companies to also prove the source of money in the hands of such shareholder or persons making a payment towards issue of shares before such sum is accepted as genuine credit”

Ensuring that the money comes from genuine investors and not those of dubious repute is imperative as the consequences for the same are dire.

Get an undertaking from investors that in case of a notice under section 68, they will furnish any details required directly to the tax authorities

In the definitive documents surrounding the proposed investment (shareholders’ agreement or share subscription agreement), ensure that every investor whose investment comes under the ambit of section 68 undertakes to give any information asked by the tax department if a scrutiny notice for section 68 is received by the company.

Do not become a middleman between the AO and your investors; ask the AO to directly seek this information from the investors under section 133(6) of the Income Tax Act, 1961.

This is the single most important point when dealing with a notice under section 68

DO NOT BECOME THE MIDDLEMAN BETWEEN THE AO AND YOUR INVESTOR

Documents sought by the AO to establish creditworthiness and genuineness of the transaction include sensitive documents like Income Tax Returns, financial statements, bank statements, etc. which investors are reluctant to share.

In case you receive a notice, submit the following documents as evidence:

  • PAN of the Investor
  • Copy of the share certificate issued and share application form filed by the investor. Share application forms are now mandated to have the bank details of the investor stated
  • The contact information of the investor like phone number, address and email ID. These are standard fields in any definitive agreement

Along with this, clearly, state the following in writing (in consultation with your lawyer or accountant as this is merely indicative)

“We, the undersigned company, have provided the details of our investors that are present with us. Upon asking them for the documents requested pursuant to the scrutiny notice dated xx-xx-xxxx, our investors have stated that they will willingly comply with the request if it is made to them directly by the AO.

Hence, we request the AO to obtain this information using the powers granted to them under Section 133(6) of the Income Tax Act, 1961”

It’s important to get this in writing as it will serve as evidence that the company has tried its best to obtain the information, but the investor is unwilling to share the same with the company but will do so directly with the AO. Several startups who have received notices under section 68 have stated the same and the AOs have reached out directly to the investors.

The recent interactions between DPIIT, CBDT startups and investors held on February 4th, 2019 and the smaller working group constituted on February 8th, 2019, which I had the fortune of being a part of, I had raised the issue of section 68 and its effects in light of the TravelKhana and BabyGoGo cases. The CBDT members present stated that in case the startup cannot obtain the information asked, they need to inform the AO and give the necessary contact details so that the information can be obtained by them. The representatives at the meeting asked for a circular to be issued for the same, which is being awaited.

The startup ecosystem has come a long way in their fight against the Angel Tax and the recent circular has addressed a majority of the asks of entrepreneurs and investors. The two pending issues of what will happen to startups who have received orders as well as dealing in shares, which comes into play during JVs, subsidiaries and acquisitions, are supposed to be resolved by the upcoming CBDT circular.

With that, the spectre of angel tax will finally become a footnote in the history of Indian startups and 68 won’t adopt that role.

Author

Siddarth Pai

Community
Founding Partner and Chief Financial Officer, 3one4 Capital

Siddarth Pai is the Founding Partner and Chief Financial Officer at 3one4 Capital, an early stage venture capital fund based in Bangalore. He is also a member of policy and regulatory consultancy panels at iSpirt, an Indian software and product advocacy think tank and works with them in advocating for startups and investors with government and regulators.

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