Amidst govt relief assurance on angel tax, startups face questioning from tax officials

Early this month, Central Board of Direct Taxes issued a circular saying that "no coercive measure" would be taken to recover the outstanding demand. Besides, the Department of Industrial Policy and Promotion (DIPP) was planning to waive off angel tax of up to Rs 10 crore for startups incorporated before 2016, according to media reports.

However, the reality is that startups are still being harassed by tax officials as they have started questioning some startups on their fundraising methods, an ET report said. These startups have raised funds from angel investors through rights offers rather than via private placements in the past few years.

Rights issue and private placement are the two ways to issue shares, other than initial public offers, through which a company can raise money in the primary market by issuing its securities. In the former method, the company proposes to issue its shares to its existing shareholders while in private placements, a company issues shares to a select group of investors, instead of inviting public at large.

Some startups had opted for rights offers because of the complexities involved in the private placement method.

The report quoted an expert who said after the rights issue, the existing investors in startups had renounced rights in favour of the new investors. This could potentially have tax impact in the hands of the investors. The tax department could levy tax after calculating the quantum of benefits in the hands of the new investors and even for the startups.

In its current form, funds from angels are taxed at over 30 per cent if it is more than the fair market value (FMV). The clause was introduced in 2012.

The so-called angel tax can be explain in another way. Though a rights issue is typically at lower valuations, startups also see drops in valuations after the funding. Now, looking back, it appears the rights issue was made at a valuation in excess of fair value. This leads the tax department to levy taxes on the difference, which is considered to be income and deemed taxable under Section 56 of the Income Tax Act.