Tax on share premium Remedy for money laundering or a startup bottleneck
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Tax on share premium Remedy for money laundering or a startup bottleneck

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Startup capital in closely held companies from residents and exceeding the ‘fair market value’, may now stand taxed at the highest tax rate of 30%. Amongst the various debatable and not so welcome amendments proposed by the Finance Bill, 2012, the proposed amendment to section 56 of the Income Tax Act, 1961 too deserves a special mention. In this columns, Archana Panchal and Tushar Ajinkya discusses the same.

By Archana Panchal and Tushar Ajinkya

Startup capital in closely held companies from residents and exceeding the ‘fair market value’, may now stand taxed at the highest tax rate of 30%.

Amongst the various debatable and not so welcome amendments proposed by the Finance Bill, 2012 (“Bill”), the proposed amendment to section 56 (“Amendment”) of the Income Tax Act, 1961 (“Act”) too deserves a special mention.

The Amendment, which seeks to tax domestic investments above the fair market value in closely held companies, has not been well received by the M&A and PE industry, particularly the capital-starved entrepreneurs.

What is the amendment?  The Bill amends section 56(2) of the Act with effect from April 1, 2013, by inserting a new sub clause (viib). The new sub clause provides that if a company, in which the public is not substantially interested, issues shares to any person resident in India for a consideration exceeding the fair market value of such shares, then the aggregate consideration so exceeding the fair market value will stand taxed as ‘income from other sources’.

The sub clause defines ‘fair market value’ to mean the higher of the value as determined in accordance with a prescribed method or the value substantiated by the company to the satisfaction of the assessing officer based on the value of the intangible or tangible assets or other business or commercial rights.

Thus, closely held companies issuing shares at a premium to residents may end up paying 30% tax on such amount of premium that falls beyond the aforementioned ‘fair market value’ threshold.

What the amendment meant to curb? The Finance Minister’s speech labels the Amendment as ‘a measure to deter the generation and use of unaccounted money’. However, the Amendment only exempts investments by venture capital funds or venture capital funds in venture capital undertakings. Thus, it brings within its radar even bona fide investments by genuine investors.

Positioned as a weapon to curb money laundering and tax evasion, it is perhaps a little early to comment as to whether this weapon will prove itself sharper than the creative intellect of the money launderers and tax evaders.

Whom does it affect? The Amendment is meant to cover companies in which the public is not substantially interested i.e., closely held companies. Thus, it covers both startups and well-established companies.

Typically, a startup is thinly capitalized. The capital requirements are met by a subsequent round of seed funding and such funding is usually at a substantial premium since the underlying assets of the startup do not support a higher fair market value. Here, the main justification for any mark up above the fair market value could be the business idea. Though that the business idea is something, which only the angel investor, in addition to the founder/promoter, believes in, it will now have to appeal to the tax authorities as well.

Further, share premiums are also a good source to wipe out any preliminary expenses or to incentivize angel investors by issuing bonus shares. The Amendment may reduce this kitty by a decent 30%.

The Amendment also poses significant challenges for the domestic M&A or PE deals, especially in acquisitions through a competitive bidding process, where the transaction price is over and above the fair market value. The domestic deal structures will now have to devised bearing in mind these additional tax implications. For instance, it would be worth evaluating if certain instruments, other than shares, can escape the Amendment. At the same time, a couple of traditional deal contours will have to be scrapped.

Was the Amendment really needed? Apart from the aforementioned amendment to section 56(2) of the Act, the Bill also amends section 68 of the Act.

The amendment, which is meant to take effect from April 1, 2013, provides that where any sums are received from a resident person as share application money, share capital, share premium or any such amount by whatever name called, then the explanation offered by the closely held assesse company will be deemed to be not satisfactory unless such resident person also offers an explanation about the nature and source of the sums so credited to the satisfaction of the assessing officer.

Previously, section 68 laid the onus on only the assesse company to explain the nature and source of the any sum found credited in its books.

It appears that the Finance Ministry does not find the aforementioned amendment to section 68 adequate to tackle money laundering and tax evasion.

Any relief in sight? The buzz is that post representations by certain affected parties, there is a likelihood of the Finance Ministry incorporating thresholds so as to exempt investments below such thresholds.

This may help angel investments provided the thresholds have been set taking into consideration the average deal sizes in such investments.

What could help?  The capital requirements for startups may vary substantially across various industries and a ‘one size fits all’ approach may prove to be unhelpful. Further, these thresholds be reconsidered from time to time to factor in any increase in the average deal sizes. The Finance Ministry may consider these aspects while setting the proposed thresholds.

It is unclear whether the revenue department will consider any innovative or unique business idea as an intangible asset, pending conversion of such innovative or unique business idea into registered intellectual property.

The Finance Ministry could also throw some more light on the connotation ‘business or commercial rights’ since the same can be relied upon while determining the ‘fair market value’. Is it restricted to only rights which accrued? So what happens when a startup is required to bid for a tender and requires capital for earnest monies and bank guarantees?

A lot would hinge upon the yet to be prescribed methodology for arriving at the ‘fair market value’.  The prescribed methodology should support the ones typically adopted by the M&A and PE industry.

While any legislation aimed at eradicating money laundering and tax evasion is extremely desirable, it is required of the Finance Ministry to ensure that at the same time such legislation does not dissuade entrepreneurial initiatives or domestic M&A activities, thereby hampering overall economic growth.

Image from here.

The authors are Archana Panchal and Tushar Ajinkya. Panchal is a manager and Ajinkya is a partner with DSK Legal, Mumbai. The views expressed in this article are that of the authors alone.

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