Demystifying the Funding Challenges Faced by Private Limited Start-up Companies

Table of Contents

1. Additional onus on start-up private limited Co. to explain ‘source of the source’ of share capital/share premium raised
2. Angel tax u/s 56(2)(viib) – share premium received by closely held companies in excess of FMV taxable

Check out Taxmann's Taxation of Start-ups & Investors which provides focused analysis, starting from recognising start-ups to their taxation. It includes DPIIT Guidelines, IMB Decisions, relevant legal provisions, Case Laws, etc. It also provides a start-up ready reckoner. This book is amended by the Finance Act 2023.

1. Additional onus on start-up private limited Co. to explain ‘source of the source’ of share capital/share premium raised

The Second proviso to section 68 of the Act casts additional onus on a closely held company to prove ‘source of the source’ in respect credits recorded in the names of residents in respect of share application money, share capital, share premium or any such amount by whatever name called. If not proved to satisfaction of AO, amount will be taxed as unexplained cash credits.

The Explanatory Memorandum to the Finance Bill, 2012 explains the object of the first proviso as under :

“In the case of closely held companies, investments are made by known persons. Therefore, a higher onus is required to be placed on such companies besides the general onus to establish identity and creditworthiness of creditor and genuineness of transaction. This additional onus, needs to be placed on such companies to also prove the source of money in the hands of such shareholder or persons making payment towards issue of shares before such sum is accepted as genuine credit. If the company fails to discharge the additional onus, the sum shall be treated as income of the company and added to its income.”

Importantly, there is no exemption for start-ups from the rigours of the second proviso to section 68 of the Act. The LSN provides exemption from Angel Tax u/s 56(2)(viib) but not from the rigours of discharging the onus under section 68.

If onus of explaining source of amounts credited in books as share capital/share premium/share application money under main provision of section 68 is not discharged, or if the additional onus of explaining ‘source of source’ in second proviso of section 68 is not discharged, by the start-up private company, then the amount so credited in its books will be treated as undisclosed income and liable to be taxed at the rate of 60% tax, 25% surcharge and 4% health and education cess (effective tax rate of 78%).

The second proviso stipulates that:

• where the assessee is a company, (not being a company in which the public are substantially interested) and
• the sum so credited consists of share application money, share capital, share premium or any such amount by whatever name called,
• any explanation offered by such assessee-company shall be deemed to be not satisfactory, unless—(a) the person, being a resident in whose name such credit is recorded in the books of such company also offers an explanation about the nature and source of such sum so credited; and (b) such explanation in the opinion of the Assessing Officer aforesaid has been found to be satisfactory.

The third proviso provides that the second proviso shall apply if the person, in whose name the sum referred to therein is recorded, is a venture capital fund or a venture capital company as referred to in clause (23FB) of section 10.

The ingredients of these two provisos in section 68 are as under:

(i) The assessee is a closely held company—a private limited company falls in the ambit of definition of closely-held company

(ii) Any sum of ‘share application money, share capital, share premium or any such amount by whatever name called’ is found credited in the books of such assessee-company for any previous year.

(iii) Such credit is recorded in the name of a resident other than a ‘venture capital fund’ or a ‘venture capital company’ [See clause (23FB) of section 10].

(iv) The assessee-company offers explanation about the nature and source of such credit. Such explanation shall be deemed to be not satisfactory unless :

(a) the person, being a resident in whose name such credit is recorded in the books of such company also offers an explanation about the nature and source of such sum so credited; and

(b) such explanation in the opinion of the Assessing Officer aforesaid has been found to be satisfactory.

(v) If such assessee-company offers no explanation or its explanation is not satisfactory or its explanation is deemed unsatisfactory as per (iv) above, then sum so credited may be charged to income-tax as income of the assessee of that previous year. However, entire share capital cannot be added to assessee-company’s income under section 68 only because some of shareholders do not respond to notices issued to them or do not satisfactorily explain the source and nature of their funds – CIT v. Nilchem Capital Ltd. [2012] 18 taxmann.com 350/205 Taxman 130 (Mag.) (Guj.)

1.1 Can the AO demand the startup furnish documents like bank statements/ITRs of reputed non-resident marquee investors?

In Raw Pressery (P.) Ltd. v. ACIT [2022] 143 taxmann.com 158 (Mumbai – Trib.) wherein, in the context of the first proviso (now second proviso) to section 68, it was held that a start-up is not expected to obtain & submit ITRs/bank statements of reputed big non-resident investors.

The Tribunal held as under:

• Where assessee-startup has raised funds by way of share capital and share premium from reputed non-resident marquee investors and has submitted to AO all primary evidences in respect of the same such as PAN Card, GBL License, Certificate of Conversion and financial statements, certificate of incorporation and Tax Residency Certificate of the investors as also Foreign Inward Remittance Certificate (FIRC), FC-GPRs and CA certificate of share valuation as required by RBI, no addition can be made u/s 68 in respect of these funds for non-submission by assessee-startup of confidential documents of investors such as their ITRs and bank statements which start-up assessee has no power to compel them to furnish to it.
• If such primary evidences have been submitted, the initial burden of assessee-startup under main provisions of section 68 stands discharged. The first proviso to Section 68 of the Act(now second proviso), which was inserted by the Finance Act, 2012 is applicable to persons who are residents, who are further required to substantiate the ‘source of source’ of funds. This additional burden cast upon by the proviso not applicable to non-resident investors.
• If AO/CIT(A) have any doubts and want to obtain ITRs and bank statements of such reputed non-resident investors, they can make the verification and enquiries from non-resident investors through proper channels by following the procedure in CBDT Circular F. No. Pr. CCIT/Neac/Sop/2020-21, dated 19-11-2020, particularly so when startup-assessee requests them to invoke their powers to obtain these details from the investors directly.

The Tribunal observed that

“although the assessee had furnished the primary evidences in support of the share premium received from these foreign investors, the lower authorities chose to sit back with folded hands till the assessee exhausted all the evidence in his possession and then merely reject the same without conducting any inquiry or verification whatsoever. Such in-action/omission on the part of lower authorities cannot be accepted.”

The Tribunal reminded and warned the lower authorities that

“the public at large and also the foreign investors who are looking at India as an attractive investment destination, have great faith and confidence in the justness of the decision making process which has serious civil consequences”.

The Tribunal further observed as under:

“In respect of the share premium received from three (3) foreign investor, we once again deprecate the inaction and non-application of mind to the facts of the case by the lower authorities, particularly when the revenue has accepted the identity and genuineness of these investors in the past years. Having held so, we also cannot lose sight of the fact that the assessee by their own admission was unable to provide all the primary evidences viz, income tax returns, bank statement, etc. of the foreign investors concerning the relevant year for verification. Understandably, these foreign investors are of repute and given the fact that the assessee was only as start-up, it may not be in a position to obtain from them all relevant documents, as desired by the AO/NFAC. However, this cannot absolve the foreign investors from verification of their creditworthiness by the income tax authorities. In our humble opinion, the right course of action for the revenue was to make independent enquiries from these investors through appropriate channel such as FT & TR etc., particularly when such manner and line of enquiry had already been laid down by the CBDT in their SOP dated 19-11-2020 or from the AO’s of the respective foreign investors. In the facts of the case discussed (supra) the revenue ought not to have simply pushed the entire burden on to the assessee to provide the details and documents of foreign share holders, particularly when the CBDT empowered them to make independent enquiries from them.”

1.2 Seamless e-verification by Department for the purposes of 2nd proviso to section 68

Although start-ups are not exempted from the purview of the second proviso, the Finance Minister, has announced that the Income-tax Department will verify the identity of the investor and source of his funds by e-verification.

The Finance Minister, in Para 113 of her Budget Speech on July 5, 2019, announced that “The issue of establishing identity of the investor and source of his funds will be resolved by putting in place a mechanism of e-verification. With this, funds raised by start-ups will not require any kind of scrutiny from the Income Tax Department.”

Item (i) of Part A-GEN in ITR-2, Item (f) of Part A-GEN in ITR-3, Item (n) of Part A-GEN in ITR-5, require details of holdings in shares of unlisted companies. Presumably, the details in these return forms will enable seamless e-verification promised by the Finance Minister.

2. Angel tax u/s 56(2)(viib) – share premium received by closely held companies in excess of FMV taxable

The ingredients of clause (viib) of sub-section (2) of section 56 are as under:

(1) A closely held company (company not being a company in which public are substantially interested) receives in any previous year from any resident any consideration for issue of shares.

• • Where assessee-company was second level subsidiary of a company in which public was substantially interested, the case of assessee-company could not fall under section 56(2)(viib). Where the assessee-company is step-down subsidiary of a listed company, assessee-company falls under the category of the company in which public are substantially interested. The subsidiary companies, viz., AHLL and assessee-company come under the definition of section 2(18)(b)(B), as per which public are substantially interested. [Apollo Sugar Clinics Ltd. v. Deputy Commissioner of Income-tax, Circle-1(1), Hyderabad [2019] 105 taxmann.com 254 (Hyderabad – Trib.)]
  • In view of amendment by Finance Act, 2023, with effect from A.Y. 2024-25, consideration may be received from any person whether resident or non-resident. Section 56(2)(viib) will apply to consideration for shares issued to non-residents also

(2) The shares may be preference shares or equity shares-it does not matter.

• In Microfirm Capital (P.) Ltd. v. Dy. CIT [2018] 89 taxmann.com 23/168 ITD 301 (Kol. – Trib.) it was held that a perusal of section 56(2)(viib) shows that all types of shares are covered by this section. The argument of the assessee that redeemable non-cumulative preference shares is a quasi-debt and that it was not the intention of the Legislature to bring such instruments within the ambit of this section, is devoid of merit.

(3) The words ‘any consideration’ suggests that consideration may be in cash or in kind.

• Share allotment in lieu of purchase consideration payable for an asset acquired is not outside ambit of provisions of section 56(2)(viib). As per provisions of section 56(2)(viib), it is ‘consideration’ received for issue of shares that exceeds face value of such shares, which is to be considered and not payment received only in cash or by cheque etc. Therefore, it could not be argued that provisions of section 56(2)(viib) could not have been invoked, because premium received was not in cash [Flutura Business Solutions (P.) Ltd. v. Income Tax Officer, Ward-3(1)(1), Bangalore [2020] 117 taxmann.com 567 (Bangalore – Trib.)]

(4) The consideration for the issue of shares exceeds the face value of the shares—in other words, shares are to be/issued at a premium.

(5) Shares are said to be issued at a premium when they are issued for a consideration in excess of their par value/face value.

(6) The Guidance Note of Terms Used in Financial Statements issued by the Institute of Chartered Accountants defines ‘Share Premium’ as ‘the excess of the issue price of shares over their face value.’

(7) The aggregate consideration received for issue of shares exceeds the fair market value of the shares: The fair market value of the shares shall be the value—

(i) as may be determined in accordance with such method as may be prescribed

(ii) as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature, whichever is higher;

Before applying provisions of section 56(2)(viib), assessing authority is required to undertake exercise of determining fair Market Value of shares as provided in provisions of section 56(2)(viib) [Commissioner of Income Tax, Corporate Ward 3(4), Chennai v. Vaani Estates (P.) Ltd. [2019] 107 taxmann.com 15 (Madras)]

(8) If conditions in (1) to (7) above are satisfied, the aggregate consideration received for such shares as exceeds the fair market value of the shares shall be taxed as ‘income from other sources’. Such tax is popularly known as ‘angel tax’. Where assessee-company received share application money in past years but the shares were allotted only in the current year, the transaction of issue of shares could be said to have crystallized in current year only. The issue of taxability under section 56(2)(viib) could not have been examined by Assessing Officer in past years when application money was received but only in current year when allotment was made. The Assessee would also be required to justify the issue price/premium with reference to FMV as determined under Rules 11U and 11UA in current year only. It is true that section 56(1)(viib) refers to consideration for issue of shares received in any previous year and it is equally true that ` 4.03 crores was received in assessment year 2012-13 and ` 40 lacs was received in assessment year 2013-14 but the fact of the matter is that the entire share allotment was done during the year under consideration; therefore, it cannot be said that the assessee was not liable to justify its share premium supported by the valuation report as mentioned under rules 11U and 11UA. The valuation report which the assessee sought to file before the Tribunal should have been filed before the Assessing Officer so that the same can be examined within the purview of rules 11U and 11UA. A part of the share application money was received in earlier assessment years; since in those assessment years shares were not allotted, the share premium could not have been examined by the Assessing Officer under section 56(2)(viib). Since the entire transaction has crystallized during the year under consideration which also includes the share premium of ` 790 per share needs to be examined during the year under consideration only. [Cimex Land and Housing (P.) Ltd. v. Income-tax Officer, Ward-6(2), New Delhi [2019] 104 taxmann.com 240 (Delhi – Trib.)] If FMV exceeds the consideration, on the other hand, whether a deduction of ‘loss’ will be allowed is the moot question. Section 92(3) of the Act clearly provides that transfer pricing provisions (which contemplate rewrite of international transactions/specified domestic transactions by substituting arm’s length price for actual transfer price) can be invoked only where it benefits the revenue and not where it benefits the assessee. Sub-section (4) of section 45, as newly substituted by the Finance Act, 2021 with effect from assessment year 2021-22, also clearly provides that the said provision can be invoked only where it benefits the revenue. If computation results in negative, result is deemed to be zero. In the absence of a clear provision, along the lines of section 92(3)/ new section 45(4) in section 56(2)(viib), it is possible to argue that where FMV exceeds consideration, the difference can be claimed as a loss since loss is nothing but negative income.

(9) The first proviso below clause (viib) provides that the above provisions of clause (viib) shall not apply where the consideration for issue of shares is received—

(i) by a venture capital undertaking from a venture capital company or a venture capital fund or a specified fund; or

(ii) by a company from a class or classes of persons as may be notified by the Central Government in this behalf.

For the sake of (i) above ‘specified fund’ and ‘trust’ are defined as under:

(aa)  “specified fund” means a fund established or incorporated in India in the form of a trust or a company or a limited liability partnership or a body corporate which has been granted a certificate of registration as a Category I or a Category II Alternative Investment Fund and is regulated under the Securities and Exchange Board of India (Alternative Investment Fund) Regulations, 2012 made under the Securities and Exchange Board of India Act, 1992 (15 of 1992) or regulated under the International Financial Services Centers Authority Act, 2019 (50 of 2019);

(ab)  “trust” means a trust established under the Indian Trust Act, 1882 (2 of 1882) or under any other law for the time being in force.

CBDT has issued Notification No. S.O. 1131(E), dated 5-3-2019, pursuant to (ii) above for exempting start ups from taxation (angel tax) under section 56(2)(viib). The said Notification provides for exemption to startups subject to fulfilment of conditions for exemption in para 4 and para 5 of the DPIIT Notification No. GSR 127(E), dated 19-2-2019 (Latest Startup Notification/LSN).