Investment above Fair Market Value – no more Angel tax for Startups

In this session we take up a long pending issue of “Angel Tax”. It has been given partial reprieve recently, under StartupIndia plan. We also discuss how startups can raise money from Angels, without getting trapped in fair market value rule of finance act 2012.

Sanjay Khan speaks on the problem, the latest announcement and the way out for startups to raise equity without DIPP route, in the below given google hangout video.

What is this issue of Angel Tax? And what changes after new announcement?

Startups receive equity infusions from various sources. One of the most lucrative and internationally prevalent source is the Individual investor (Angels).

In India income tax department is skeptical about angel investment. This is because, at times angel investment was misused to channelize black money. Artificial valuations is mostly the doubt in mind of income tax authorities.

As per, Finance Act 2012, capital raised by an unlisted company from any individual against an issue of shares in excess of fair market value would be taxable as ‘income from other sources’ under Sec 56 (2) of the I-T Act. This came to be popularly called as angel tax.

So, if fair market value is say e.g. Rs. 10 per share and a startup receives Rs. 15 investment from an Angel investor. Income tax treats this difference i.e. Rs. 5 per share, as income.

As per the above provisions, the angel investments are subject to assessing officer’s approval. The jurisdictional assessing officers of income tax enjoy the discretionary powers. Instances of misuse of these discretionary powers by assessing officers created problems for startups.

Many startups are not serious about the documentation. Mostly, such startups get into problems due to lack of documentary evidence about their valuations.

Govt. of India recently announced a change under StartupIndia policy of DIPP. A Central Board of Direct Taxes notification, dated June 14, made the required changes to Section 56(2)(viib) of the Income-Tax Act, exempting startups raising funds from angel investors. This is limited to the startups approved by DIPP.

Is it available to all DIPP registered startups?

No, not to all startups approved or recognised by DIPP.

There are three kinds of startups now.

(a) General Startups, that have not applied to DIPP or are not even eligible to apply to DIPP.

(b) those who applied and got recognised by DIPP but did not apply for Income tax exemption.

(c) those who fall under (b) and also got the income tax exemption approval of the inter ministerial board of DIPP.

Only the third (c) category of startups are eligible. These startups need not worry about the assessing officer discretion now. The benefit is available so long as they enjoy the income tax exemption under startup policy.

So, if this is not applicable to all startups, does it mean other startups cannot raise equity from Angel investors at all?

The Finance act 2012 provision does not bar angel investments. Startups not under (c) above can raise the investment from Angels (individual investors). The limitation is that the valuations in such cases will  be subject to examination by assessing officer approval.  They have to extra careful about the valuation at each round of funding.

Such startups should get a professional third party valuation reports. Get a valuation reports for all rounds of valuations with proper documentary proofs. You can face the assessing officers with proper documents without any fear.

The recent hype created in media was mainly arising from down rounds. That is when the new round of investment was done at a lower rate than the previous round. This led to income tax doubting the misuse.

In such challenging valuation situations like down round valuations, the startup can get a professional third party valuation from 2 or 3 sources. This way they can deter the assessing officer’s misuse of discretionary power as well as stand any litigation test, if put through.

In essence, a startup can raise honest angel investment at right fair market value. A professional valuation exercise with all objectivity can help you cover the risk.

iSPIRT’ stand

Startups ecosystems in developed countries enjoy a favourable investment climate that proactively promote and protect the angel’s investments.

Government of India should show give clear signal of favourable investment climate in the country.

Government of India should think of measures that can deter black money getting invested in the Startups, instead of doubting each and every investment. For this Govt. should repeal the the provision introduced by finance bill 2012 should. Discretion to assessing officer is not serving the cause of building investment climate.

India seriously needs a policy that promotes angel investments in general, with responsibility of money invested taken by investors rather than Startups.

Demystifying Startup Tax

Over the past couple of days, a lot has been written/discussed about the so called ‘startup tax’ and its perceived ill effects on the startup ecosystem. Under iSPIRT’s new initiative, PolicyHacks, I attempt in this note to demystify the legal/tax jargon around this tax and to clarify the proposed rule for the benefit of ecosystem participants, particularly startups.

What is the law?

Simply put, if a private company issues shares to a resident Indian at a price above the fair market value (FMV) – say the FMV of a share is INR 100 and the company issues it at INR 110 – then the excess consideration (INR 10 in this case) is considered to be the company’s income (since, in a way, it deserved INR 100, but received INR 110). The amount of INR 10 is, therefore, liable to be taxed as the company’s income (which presently is at a rate of 30%). FMV is an important element here, and we will get back to it later. It is popularly called the ‘angel tax’.

Who are exempted from this?

As highlighted above, this provision is applicable only to investments received from resident Indians. Thus, at the first level, it does not affect foreign investments. In addition, the provision does not apply to investments made by SEBI-registered entities. One, therefore, need not worry about money received from angels/VCs/PEs which are either investing from foreign sources or have been registered with SEBI.

Who are hit by this?

Whoever is not covered under the above exemptions or otherwise exempted by the government. Prominently, the Indian angels (which constitute an overwhelming majority of the overall angel investors). Hence, the term ‘angel tax’.

What is ‘startup tax’ then?

As is clear from the above, the law is applicable to all private companies and does not single out startups. However, it has been reported in the media lately that startups which have raised down-rounds will be scrutinised by the tax department, and the valuations of such down-rounds will be considered to be the FMV of all previous (up) rounds.

In other words, if:

  • in the last round:
    • the valuation of the company was INR 1,10,00,000; and
    • the FMV per share was INR 110;
  • in the present (down) round:
    • the valuation of the company is INR 1,00,00,000; and
    • the FMV per share is INR 100,

then the valuation of the down-round, i.e., INR 100 will be considered to be the FMV of the previous round.

Hence, applying the law set out above, anything received by the company in excess of the FMV (in this case INR 10 per share) becomes its income, and is taxable as such.

So what is new in this?

Nothing. There is no change in the law. The issue that the industry has been facing since the introduction of this law is that the income-tax officers (who have wide ranging powers) were found to be using this provision to harass companies.

I have raised money from resident Indians and now I expect a down-round; will the tax department come after me?

Since this is not a new or proposed law, nothing stops the income-tax officer from going after any company even today. In fact, such proceedings have been initiated against quite a few companies in the past.

The key thing here to note is this – No tax can be levied on a company just because it has raised a down-round. The only money that this provision permits to tax is the consideration received by a company in excess of the FMV. It is a settled principle that each funding round can, and quite often, is raised at an FMV different than the previous round. So long as one can justify that in a down-round, the fall in FMV is on account of genuine external factors, and not because the FMV in the previous round was artificially inflated, one should be fine. Thus, even if one receives a notice from an income-tax officer in this respect, all one needs to demonstrate is that the FMV in the last round was calculated in accordance with the valuation mechanism provided under the IT Act, and there was no foul play in that respect. For startups falling in this category, there is nothing (or not much) to worry about, at least prima facie.

iSPIRT view and efforts

At iSPIRT, as part of the Stay-in-India initiative, we have been in continuous discussions with the government to rationalise this provision to ensure that genuine investments using legitimate money (such as angel investments) are not hit by this provision, and there is no unnecessary harassment.

Also, the government has exempted startups (which register on Startup India portal and are approved by the inter-ministerial board) from income-tax. Thus, ideally, such qualified startups should be exempt from this tax as well. We continue to discuss this with the government.

Author note and disclaimer: PolicyHacks, and publications thereunder, are intended to provide a very basic understanding of legal/policy issues that impact Software Product Industry and the startups in the eco-system. PolicyHacks, therefore, do not necessarily set out views of subject matter experts, and should under no circumstances be substituted for legal advice, which, of course, requires a detailed analysis of the relevant fact situation and applicable laws by experts in the subject matter on case to case basis.

Clearing the confusion on – SOFTEX form filing need

There are instances, when Software exporting companies operating outside an export oriented scheme (STP, SEZ, EOU etc.) are advised, that there is no need for them to file SOFTEX forms. The young entrepreneurs in Startups, obviously get confused on this. In some cases, companies stopped getting SOFTEX certification done, after complying in past when they moved out of STP/SEZ schemes, owing to this advice.

There are always two parts to deal with regulatory compliance. One, the policy aspect and second, the procedural aspect. There is lot of material available on internet, on the procedural (process) part of filing SOFTEX form. And perhaps none, that explains the policy aspect.

This article is meant to clear the confusion on SOFTEX form among the Software product community by explaining the policy aspect of SOFTEX and background process, in the realm of foreign trade regulations.

Why and how SOFTEX form came in to existence?

In general exports means sending ‘goods and service’ to clients in foreign country (outside territorial borders of India) for purpose of sale. Physical goods are exported through a physical port of shipping (a sea port, airport or foreign post office) monitored by Central customs department.

When physical goods leave borders, from any port of shipment, the exporter is required to declared value of goods. In India, this was done through a form called GR form (PP form in case of exports by post office) for non-EDI ports and SDF for EDI ports, along with invoice and other supporting documents. Recently, as part of simplification of process, the GR and PP form have been substituted by a new form called ‘EDF’ (export declaration form) and SDF has been merged with shipping bill. Please see RBI circulars. RBI/2013-14/254 A.P. (DIR Series) Circular No.43 September 13, 2013) and RBI//2014-15/599, A.P. (DIR Series) Circular No.101, May 14, 2015.

This value declared is required to be accepted and certified by the customs office, at the port of shipment. This is called “valuation of export”. Once the valuation of export is complete, the value is accepted both by RBI and its authorised dealer (the exporter’s bank). RBI then monitors, the remittance of an equivalent value in exporter’s bank account.

A ‘Software’ exported on a media (CD/DVD, magnetic tapes etc.) has to pass through these steps, as it is exported physically through a port of shipment, as physical goods.

In early 1990s, when Software Technology Park (STP) scheme came in to existence, the need to export Software through data communication links emerged. Customs department had difficulty in managing this, as nothing physical was visible in a Software transmitted, as well as did not have human resources and knowhow to deal with exports through telecom links.

DeitY (then Department of Electronics) enabled an innovation in government policy and could get RBI to announce SOFTEX form as an alternative to the GR/PP forms, to suit the export of Software, through data communication links.

STPI being the administrative authority of STP scheme, became the designated authority for “Software export valuation” and certification of SOFTEX form, in place of Customs. As on date the jurisdictional STPI Directors and SEZ Commissioners are the designated authority for SOFTEX valuation.

The purpose, policy and process of SOFTEX form is same as in GR/PP (or new EDF) form.

The only policy point difference between GR/PP or EDF form and SOFTEX form is that GR/PP forms are submitted and valued, simultaneous to the exports actually happening from port of shipment. Whereas, SOFTEX form is a post-facto approval, after the actual export of Software has actually taken place.

An important policy aspect to understand here is that before the SOFTEX form was launched the Software was put at par with ‘goods’ in the foreign trade policy, as policy makers could not conceive a trade in anything that is not ‘goods’. Even today, a services export in non-IT sector does not need any declaration or export valuation. Therefore, Software (IT and ITeS) was given a special status in international trade equivalent to ‘goods’.

Valuation of exports by Customs/STPI/SEZ is a crucial part of process

As described above, there are two policy aspects embedded here,

  1. Regulation of foreign remittances by RBI against export done by exporter (the origin of this procedure and policy behind lies in the name of GR form – “Guaranteed Remittance”) and
  2. Valuation of export done by Customs officials at port of shipment (by STPI/SEZ for SOFTEX)

The second part of the process is “valuation of exports”. Exporter declares the value of exports supported by relevant documents. The designated officer in customs/STPI/SEZ considers and certifies this value and has all right to reject the value declared or examine any declaration for overtly undervaluation or overvaluation. The process is very smooth and in more than 99.9999% cases the value is accepted and certified. Rejections are only subject to a real doubt, unlawful trade happening and exporter not able to justify genuine exports. The valuation is done under the Customs Valuation (Determination of Value of Export Goods) Rules. Since there is no separate rules defined for ‘Software’ and the export oriented units (STP, SEZ, FTZ, EPZ) operate under customs bond, the same rule applies to ‘Software’. In absence of a rule for non-EOU exporters the law would rely on same rule as well.

An export of goods and software without valuation is incomplete. RBI depends on designated officers for this valuation exercise as they are the ones who have delegated powers under the constitution to do so.

A form not certified by jurisdictional designated officer is incomplete, legally.

Who should not file EDF or SOFTEX?

An exporter of physical goods has no option other than filing EDF, as goods passes through the port of shipment managed by customs. Similarly, exporter registered under STP and SEZ has no option as the value to be accounted as exports by exporter is taken from the SOFTEX forms signed in name of the exporter.

Exporters of Software (both IT and ITeS companies) not registered in STP or SEZ (or other EOU schemes) scheme should also file SOFTEX, as per foreign trade policy.

Such exporters popularly called non-STP units can file for SOFTEX with jurisdictional STPI Director.

Only those exporters whose exports are not goods or Software can escape the filing of SOFTEX. The foreign remittances received as exports proceeds, without certification of EDF (replacement of GR/PP form) or SOFTEX form will fall in two categories, either a general service or an unlawful remittance.

Exports of services that do not fall under IT and ITeS category are exempted from filing the export declarations and certification required thereof.

What is covered under the term ‘Software’ in RBI circular

The RBI circulars on SOFTEX mentions exports of ‘Software’. It implies both IT and ITeS exports. The genesis lies in how foreign trade policy evolved, ever since STP scheme was added to the bandwagon of export oriented schemes.

‘IT’ covers both Software services and Software products (including SaaS). Software services is a whole lot of things from consulting to design, development, implementation, maintenance, re-engineering of Software or a Software product.

‘ITeS’ covers all those services that are delivered to clients across borders of India using an IT driven system and process over a telecom/internet link (include BPO, KPOs, Digitization, Call centers, Data processing etc.).

What happens if exporter does not file SOFTEX (or alternative EDF) form?

If SOFTEX (or EDF in case of physical exports) form is not filed, and exports proceed is realized, the remittance received is either treated as ‘general services’ or not as an export proceed or illegal.

For general services such as management consulting, technical services there is no declaration form.

Advice for Software product including SaaS companies

For Software exporting companies not operating under STP or SEZ, it is possible to bypass and get remittances without filing SOFTEX or EDF, under the guise of a ‘service’ export. There is no immediate threat of non-compliance, unlike the exporters in STP or SEZ.

However, not getting classified as ‘software’ can create problems in future. First problem created is your exports are not ‘Software exports’. The other problems can erupt from regulations in other areas of taxation etc. Complex Service tax rules can create problem. Any situation, where an exporter will need to prove and protect herself can end up in to a nightmare.

The important part here is the export valuation process by STPI, SEZ or Customs. Once EDF/SOFTEX form is certified, your export is also certifies as export of ‘Software’, under foreign trade policy.

For Software product companies including SaaS companies, is it advisable to mandatorily file SOFTEX form or and EDF form for Software product export in physical media, even when they are not part of STP, SEZ or similar schemes.

iSPIRT efforts in further liberalization of SOFTEX \EDF

Many argue, why this documentation. The need to declare export value, monitor foreign remittances, export valuation and balance of trade & payment accounting will not vanish for a nation state. There has to be some minimal documentation and process to fulfil all these needs.

However, there is scope for further liberalization and need for an easy liberal regime for ‘ease of doing business’.

iSPIRT is aiming for a 100% “Digital” SOFTEX and EDF run under aegis of RBI, where the process can be executed and compliance completed even at single invoice level or a monthly consolidated statement level, based on various practical needs, with export declaration fully ‘dematerialised’.

This is much needed for a ‘digital economy’ and can be a boon for exporters especially in SaaS segment and startups, where orders and invoices are generated online. And online interface can be extended in to a fully ‘digital’ export declaration regime of RBI.

India to progress to a Product Nation, in a digital world, has to take some of these steps. Sooner the better.