The Delhi HC has awarded Indian startups with a much-needed respite from angel tax!
Many startups, for a variety of reasons, are extremely overvalued at times. However, the Delhi High Court has refused to tag them all as bad apples.
Quite recently, whilst hearing a case between the Income Tax Department and Cinestaan Entertainment, the court formed a view that the valuation of a company can not be challenged based on actual data later on if a proper methodology was used to calculate the same in the first place.
Basically, this means that startups, post this ruling, can now protect themselves from taxmen unfairly slapping angel tax on any premium, as long as their method for calculating valuations stands to sound.
This will especially help startups that raise funds based on future projections and valuation reports but eventually fail to achieve the promised growth within a stipulated time period.
The concept of angel tax was introduced in the year 2012 by the then Finance Minister Pranab Mukherjee. Angel tax is levied on the capital that is raised by unlisted or private companies if and when the price of its shared happens to exceed their fair market value. The excess value is considered as income and on those grounds, it is taxed at 30%.
In April 2018, the GOI, taking note of how angel tax might be slowing down the growth of the Indian startup ecosystem, announced startups would be exempted from the tax for investments up to Rs 10 crores (provided certain conditions regarding the investor’s worth and the income of the company was met).
But soon after, in December 2018, close to 25 startups and a few angel investors started receiving notices from the IT department to pay up the taxes based on angel funding they had raised a few years ago.
Finally, in August 2019, the present Finance Minister Nirmala Sitharaman declared that angel tax will not be levied on startups only if they happened to be registered with DPIIT aka he Department for Promotion of Industry and Internal Trade.
Since then, from a total of 1,867 startups getting exempted from the controversial Section 56(2)(viib) of the Income Tax Act aka ‘angel tax’ as of December 31 2019, the number has increased to a whopping 3,612 Indian startups as of February 3, 2021.
However, the latest Delhi HC’s ruling might be able to extend the tax break beyond DPIIT registered startups as well.
In the case of Cinestaan Entertainment, the Income Tax Department mentioned that the company had come in for ‘limited scrutiny’ as it had been the recipient of a large share premium during the assessment year, and it had a minuscule income when compared to investment received.
The Delhi High Court then observed that the tax department had rejected Cinestaan Entertainment’s valuation without any proper reasoning and also failed to provide an alternative value of the company’s share.
Thus, in the judgment passed, it said the court doesn’t find any dispute in the adopted methodology of the company as it is well recognised and an accepted method.
It also mentioned that this approach of the IT department to tax companies lacks a ‘material foundation’ and stands to be irrational because valuations are intrinsic in nature and based on projections affected by several different factors.
Undoubtedly, the latest ruling of HC has provided much-needed relief to a sizeable number of thriving startups that end up paying a huge amount in angel tax to the Indian government. It would also be interesting to see whether all those startups who have already paid such tax can claim it back from the government or not.