Start-ups issuing shares at premium – Beware of Sec 68 tax trigger!

Startups issuing shares at premium out of tax trigger

In recent times, the Government of India has been offering various incentives to simplify the startup regime, encourage entrepreneurship and give an overall boost to the startup space.

The Department of Revenue recently followed suit and extended a notable incentive under the Income-tax Act, 1961 (‘the Act’), to startups who receive investments from resident persons for a consideration which is in excess of the face value of shares of such startup company.

Trend of issuance of shares at premium

Issue price of share including share premium is a subject matter of financial planning and negotiation between the company and its investors. Shares are issued at a premium with a view to strengthening capital base keeping share capital low so that servicing of share capital (by paying dividend and issue of free shares/ bonus shares) is easy and better in future.

However, the Government viewed this as a mechanism to investors to introduce their undisclosed incomes. Acting on this conception, the Government vide Finance Act 2012 (‘FA 2012’) introduced an anti-abuse provision vide clause (viib) to section 56(2) of the Act.

Taxability of share premium

Section 56(2)(viib) aims to tax the share premium received in excess of fair market value (‘FMV’) of shares of a closely held companies ‘Income from other sources’ in the hands of such recipient company.It is important to note that provisions of this section are applicable only when the consideration for issue of shares is received from a resident person.

FMV for this purposes shall be as per the Net Asset Value (‘NAV’) or Discounted Cash Flow (‘DCF’) method to be computed in accordance with rules (Rules 11U and 11UA of the Income-tax Rules, 1962).

However, provisions of this section do not apply to ‘classes of persons’ as notified by the Government. 

Further, investments by non-residents are outside the purview of this section. As a result, the provisions of this section pose a challenge where resident investors are willing to invest in domestic ventures especially when participation by domestic investors in the investment space is witnessing a decline. 

With a view to extend relief to companies falling under the ambit of section 56(2)(vii-b), the Central Board of Direct Taxes (‘CBDT’) vide its notification (Notification No. 45/2016, F. No. 173/103/2016-ITA-1 dated 14 June 2016 issued by CBDT) has notified ‘classes of persons’ being a person, as defined in section 2(31) of the Act, who is a resident, who makes any consideration exceeding face value for issue of shares of a ‘startup’ company. 

For the definition of ‘startup’ eligible for the above-mentioned exclusion, CBDT has referred to ‘startups’ as defined in the notification issued in February 2016 byDepartment of Industrial Policy and Promotion (‘DIPP’), whereby an entity shall be considered as a ‘startup’:

1. Up to 5 years from its date of incorporation / registration;
2. If it is a private limited company (i.e a closely held company);
3. Its turnover for any of the financial years has not exceeded INR 25 crores;
4. It is engaged in a business which involves innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property;
5. It obtains a certificate of eligible business from Inter-Ministerial Board of Certification (‘IMBC’); and
6. It is not formed by split up or reconstruction of an existing business. 

Further, DIPP has laid a list of documents to be submitted for recognising an ‘eligible startup’. Any one document from the following illustrative list shall be submitted along with the application:

• recommendation from an Incubator established in a post graduate college in India or recognised by Government of India;
• or a letter of funding of not less than 20 percent by an Angel Fund/ Incubation Fund/ Private Equity Fund etc;
• letter of funding from Central or State Government as part of any specified scheme to promote innovation etc, to name a few

Thus, in a scenario where a startup fails to get awarded the status of ‘eligible startup’ by DIPP, the premium received on issue of shares needs to comply with the valuation norms prescribed, to mitigate tax exposure.

Having said that, the question still arises as regards applicability of the CBDT’s notification to prior investments.

Another interesting correlation is that of the CBDT’s notification with section 68 of the Act. FA 2012 amended section 68 which deals with taxability of unexplained cash credits.

Section 68 provides that any sum credited in the books of a closely held company on account of share application, share capital, share premium or any such amount shall be treated as ‘unexplained cash credits’ and taxable in the hands of the company, if the source of such investment made by a resident is not substantiated.

However, an exclusion from the above-mentioned taxability is available in a case wherein the person in whose name such sum is recorded in the books of the company is a venture capital fund or venture capital company under the Act.

Although the CBDT’s notification gives relief to startups from compliance with valuation norms, it has not addressed the tax trigger under section 68. Hence, scrutiny under section 68 could still arise in a case where shares are issued at a premium by startups.

While there are aspects which require further clarifications, the benefit offered by CBDT cannot be marginalised. This notification would put to rest the recent controversy wherein certain reports suggested that the tax department was contemplating a move to impose tax on those startups who had received funds in excess of the fair market value of their shares.

From a holistic perspective, if clarity on applicability of section 68 is provided, it would be a welcome relaxation which will ensure that startups can issue shares to investors at higher than fair value without worrying about tax consequences.