Start-up exemption from Sec 56(2) taxability - beneficial for non-start ups too?

A dip in the holy river Ganga is believed to have a purifying effect by immunising from ill effects of sins committed by one.  Whether an investment in a start-up has some similar immunising effect on ‘angel investment tax’?  Let us see.

Section 56 of the Income tax Act, 1961 (‘the Act’) remained innocuous till year 2004 when, Vide Finance (No. 2) Act, 2004, cash gifts were brought to tax net by inserting clause (v) to sub-section (2) thereof.  Since then, this section has taken many twists and turns.  Now we will focus in clause (viib) introduced vide Finance Act, 2012.

Earlier, it was possible in some situations to (ab)use corporate structure by issuing shares with miniscule voting right at hefty premium ensuring that unaccounted money is channelized without diluting control over the company.  Said clause (viib) is a legislative response to such situations. It states that, if a company (not being a company in which public is substantially interested) receives, in any previous year, premium on shares issued and that if the share issue price exceeds fair market value[1] (FMV) of shares, then the excess shall be taxed as ‘income from other sources’.  This clause also provides for two exceptions. Firstly, consideration for issue of shares received by a venture capital undertaking from a venture capital company / fund. Secondly, consideration for issue of shares received by a company, if it is given by a class of investors notified by Central Government in this behalf.  It is important to note here that it is not the recipient company that could be notified but only the ‘class of investors’.

The provision, understandably introduced to curb a menace, started hurting start-ups when they sought funds based on their business potential justifying a share valuation much higher than the statutorily computed FMV. Various industry associations highlighted this in their pre-budget memorandums.  However, Finance Bill 2016 disappointed them on this front.  Addressing the high demand from all corners, a notification[2] was issued notifying the ‘class of persons’ for the purposes of section 56(2)(viib) of the Act as any ‘person’ defined under sub-section (31) of section 2 of the Act, being resident, who makes any consideration exceeding the face value for issues of shares of a ‘startup’[3] company.

This notification gives rise to interesting situation.  Suppose Mr. NI invests in a start-up company ‘S Ltd’. He also invests in P Ltd. (not being a start-up) wherein shares are issued to him at premium and at value exceeding FMV.

As the law now stands, since Mr. NI would be an Notified investor, both S Ltd. and P Ltd. would be protected from the operation of section 56(2)(viib) of the Act.

It is evidently an unintended consequence that resulted due to hurried damage control exercise of addressing industry need by a patch-work notification while the current text of statute required a parliamentary intervention. Be it as it may, till it is revisited, the notification is likely to be a shield for various non-start-up investors who may take a small dip in the ‘Start-up Ganga’ to obtain immunity from angel investment tax.

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[1] As per Rule 11U and 11UA of Income tax Rules, 1962