Taxman looks at startup valuations via rarely-used provision Innovation

Many startups are being asked to explain their ambitious valuations by tax authorities.
Despite losing money, such closely-held businesses often sell stocks to investors at steep premiums based on growth projections. However, they may find themselves vulnerable before the taxman if the business projections go haywire or assumptions that go into pricing of shares and valuing a company appear unrealistic.

In recent months, the tax department has questioned the valuation of several startups by invoking a sparingly used feature of the law that empowers the principal commissioner or commissioner to revise the order passed by the assessing officer.

“Many of our members, including some which are registered as startups with the commerce ministry, have received notices under Section 263. The powers under section 263 of the Income Tax Act are to be invoked on satisfaction of twin conditions of the order being both erroneous and prejudicial to the interests of the Revenue. The action by the Department revisiting the valuation is in fact negating the benefits accorded to DPIIT registered startups and investors. We will take this issue with the CBDT as this brings uncertainty in the startup ecosystem,” said Mahendra Swarup, chairman of the industry body Startup Association of India (SAI).

Companies which are recognised as ‘startup’ by the DPIIT (or, the Department for Promotion of Industry & Industrial Trade (DPIIT) — and fulfilling certain conditions — are spared of the tax (under section 56 (2) (viib) of the Act) that other unlisted companies have to pay on the amount received by way of premium over the fair market value (FMV). While startups arrive at the FMV as per the methods laid down by the department, tax officials can question the parameters and assumptions in calculating the final valuation.

“Say, a company received share premium for the assessment year 2015-16, showing a valuation of 10x. But if numbers in the subsequent years since then had dropped sharply, the department may conduct enquiries saying that the real valuation is 4x, and the balance 6x should be taxed. With valuation collapsing, in hindsight the share premium received looks inflated. Similarly, valuations arrived in 2019-20 or 2020-21 can be questioned as growth has come down,” said Sachin Kumar BP, partner at the CA firm Manohar Chowdhry & Associates.

The tax office can also deny tax exemption (from section 56 (2) (viib)) if a startup is found to have given false declaration or violated conditions by investing in land. “However, recent enquiries and use of revisionary power relate to questions over valuation,” said Sachin Kumar. Startups, claiming tax exemption, have to file self-declaration with DPIIT stating they have not invested in specified asset classes. DPIIT transmits the information to the apex direct tax body CBDT. If the tax office comes to know that information filed is incorrect it may further scrutinise the matter.

“Keeping in mind the underlying aim to ease compliance and promote startups, genuine startups ought to be assessed differently and not be exposed to unnecessary compliances or have their business rationale and commercial wisdom behind claiming angel tax exemption questioned,” said Priyanshi Chokshi, a chartered accountant and senior associate at Adarsha Advisors LLP, a consultancy.

While notices have been served to startups which are recognised by the government, the unregistered startups may find themselves particularly vulnerable. Also, CBDT needs to come up with some guidelines for dealing with cases prior to the issue of guideline notifications of 2018 and 2019 to put the litigations and controversies to rest, said Nirav Jogani, director at RSM Astute Consultech. “The angel tax issue fails to die down even after years of representations, statements and notifications. Cases are being reopened especially in cases where the premiums are big. The CBDT needs to come up with some guidelines for dealing with cases prior to the issue of guideline notifications of 2018 and 2019 to put the litigations and controversies to rest,” said Jogani.

The CBDT spokesperson did not comment on the subject.

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