Where ‘angels’ are bedevilled

Targeting share valuation causes pain for start-ups. Restraining shell firms needs a different approach

For the past few months, ‘angel tax’ issues have taken centre stage. Circulars have been issued with the hope that the matter would be resolved to everyone’s satisfaction. The Department of Promotion of Industry and Internal Trade (DPIIT) is attempting to move a fresh set of solutions to pour water on this raging issue.

From the face of it, a public policy meant to curb shell companies has turned into an attack on genuine investments; and, the solution itself has become a problem. Does the Department need to take a fresh look at Section 56 (2) in light of the visible outcomes of a public policy gone wrong? We will wait and watch. Till then, let us revisit the issue itself.

The focus was on promoting private sector investment in the country. This being the base, all other processes and rules should run consistent with this foundation. But, it is this premise which is taking a beating and hence the need to address it.

Every investor has a view as to whether a venture is worth investing in, by calculating likely returns. The entrepreneur seeking investment has also determined the extent of control and ownership to be surrendered in return for funds.

Both balance their interests to secure the maximum possible returns. To protect their respective long-term interests, both would be unwilling to compromise on their view. In case of doubt, the investor has recourse to the business plan to convince himself that his assumptions are accurate.

Now, into what should be entirely the domain of the ‘private’ sector, we have brought ‘governmental control’, to the extent that whatever deal may be struck between the investor and the entrepreneur, they are plagued with having to satisfy a clause which can be a threat to the entire venture on account of an unfactored tax burden.

Section 56 (2) (vii)(b) of the Income Tax Act provides for ‘where a closely held company issues its shares at a price more than its fair market value, the amount received in excess of the fair value will be taxed as income from other sources’. The determination of fair market value becomes the bone of contention. It now comes under the domain of the ‘Assessor’ — meaning the Income tax department. The department takes a look at the business plan and begins to check whether the turnover and business returns envisaged were achieved.

Valuation stalemate

If they weren’t, the department faults the business plan and concludes that the valuation was much higher than what it should have been. Most businesses in our country are subject to flux on account of laws that are constantly being moved around. Then there is the market situation which is not guaranteed, either. Even if the investor is willing to wait for returns, the tax department is not. Due to volatile markets, coupled with tax issues, most financial advisers do not recommend formation of private limited companies. Strangely, it is common to find in recent times businesses — that could have easily benefited from the private limited tag and then becoming public limited companies — still remaining as partnerships or worse, sole proprietorships.

Our ecosystem is not conducive for real growth in the private sector unless you have learnt to ‘handle the system’.

If the government is concerned about ‘shell companies’, it would need to attack the issue head-on and define a shell company. What would qualify a company to be one? Once the identity of a shell company has been determined, the penalty for the same can then be decided.

This would be better than targeting share valuation in a company, which is crucial to attracting investment. Currently, there is no distinction between a company functioning with genuine transactions and one that isn’t.

Some food for thought: isn’t it sufficient that the share premium and the stake offered satisfy promoters and investors? Is there a need to lay boundaries to this aspect of free market enterprise? Is fair market value constant and consistent, year-on-year; and are extraneous influences the same all around?

Laws inadequate?

If money in excess ‘appears’ to be pumped into a private limited company and the source of such funds doubtful, aren’t existing laws (Section 68 or 69 of the Income Tax Act, 1961) sufficient for the authorities to determine and tax accordingly without having to enter into the share valuation sphere?

Is Section 56 (2)(vii)(b) of the Income Tax Act, 1961 deterring the flow of investments into private limited companies? If it is non-negotiable and will continue to remain so even for the most straight-forward transactions, how can genuine private limited companies that seek capital infusion for expansion/consolidation be protected from interpretations that could lead to layers of litigation with huge tax levy to be fought at different levels up to the apex court?

Currently, consultants often discourage entrepreneurs from forming private limited companies due to factors that influence ease of investment and functioning.

Public policies in this area directly impact the ecosystem affecting the growth of private limited companies. Perhaps, ‘angel’ tax has got to go if private limited firms are to flourish in India.

(The writer is Retired Additional Chief Secretary, Govt. of Tamil Nadu)

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