Key Issue Plaguing Startups And Indian Investors Recommendations

1. iSPIRT – Indian Software Product Industry Round Table is a non-profit think tank formed by leading practitioners of the industry
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Section 56(2)(viib): KEY ISSUE
PLAGUING STARTUPS AND INDIAN
INVESTORS AND
RECOMMENDATIONS
By T.V.Mohandas Pai, Siddarth, Nakul
Ispirt

2. Overview
2
▪ Overview of the Indian Startup ecosystem
▪ Section 56(2)(viib)
▪ Current issues facing startups
▪ Analysis of high premia amongst Indian startups and orders
received
▪ Effect on domestic investors and investments
▪ Practices in other countries
▪ Measures for aggrieved companies:
 Short term
 Long Term
▪ Annexures

3. Section 56(2)(viib)
3

4. Section 56(2)(viib)
4

5. Section 56(2)(viib)
▪ Introduced in 2012 by the UPA Government
▪ Issued under “Measures to prevent generation and
circulation of unaccounted money”
▪ Taxes as income any capital receipt in “excess” of the
fair market value of the securities issued by a private
company (Annexure 1)
▪ Has become an “angel tax” on capital raised by
startups only from Indian domestic investors, not
foreign investors
▪ No other country discriminates against domestic
investors in this fashion 5

6. Current issues facing startups
▪ Unfairly attacking high share premium of startups and private
companies and taxing the difference between book value and
the DCF projections as income
▪ High share premium cannot be the basis as its an outcome of
valuation, not the cause for high valuations
▪ Issue Price = Enterprise Valuation/No of shares issued
▪ Issue Price consists of: Face Value + Share premium
▪ Thus a small issued share base and low face value result in a
high share premium
▪ Stated motive of taxing unaccounted funds coming in as
premium has been replaced by indiscriminately taxing all
premiums!
6

7. Reason for high share premia
amongst startups
▪ Pvt Ltd companies don’t have a minimum share capital
requirement any longer (Companies (Amendment Act) 2015)
▪ Thus entrepreneurs start companies with a small issued
capital and look to raise funding at the earliest in order to
scale their business
▪ Most entrepreneurs start companies with an issued capital of
10,000 shares of Rs 10 each
▪ Thus even a valuation of Rs 10 Cr (1.43 Million $) will yield a
premium of Rs 9,990!* Thus a high share premium is a
natural outcome of valuation, not the cause of valuations
7
* Share issue price = Enterprise valuation/no of shares issued
= 10Cr/10,000 shares = Rs 10,000
Issue Price consists of Face Value + Share Premium
FV = Rs 10, thus Premium = Rs 9,990)

8. Analysis of Notices and Orders
In the 60 scrutiny notices and assessments orders analysed by Ispirt, the
most common issues are:
▪ Valuation report submitted by the startup were disregarded
▪ Valuations done by the AO using a different method (Book Value) instead
of the chosen Discounted Cash Flow method, resulting in a manufactured
difference between the issue price and FMV
▪ Book Value is not appropriate as it’s the present value of the assets while
DCF looks at the future earning potential – both have different
approaches and significance and usage cases.
▪ Investors look at future earnings, not current assets. Most startups also
have an asset-light business model.
▪ Stated budget measure of unaccounted funds is ignored as the nature or
source of funds not examined, only the premia is taxed as income!
8

9. 9
Effect on Domestic Investments

10. Indian startups have the lowest
valuations worldwide!
10
Silicon Valley
Europe
Israel
India
Source: Angellist - https://angel.co/valuations

11. Domestic early Investments decline
while other investments rise
11
Nasscom report – Indian Startup ecosystem Approaching Escape Velocity – Edition 2018

12. No of Early stage rounds is down
28.5%
INVESTMENTS IN START-UPS BY ROUND
Year Seed Series A Series B Series C Series D Series E+
2014 91 145 56 28 11 10
2015 208 257 93 41 12 11
2016 198 186 102 45 20 11
2017 174 154 101 30 21 15
2018 148 137 83 62 24 15
12
Source: Venture Intelligence

13. No. of unique domestic investors
down 48% since 2015
13
Inc 42 – State of the Indian Startup ecosystem - 2018

14. 14
Practises in other countries

15. Practises in other countries
▪ No other country discriminates against domestic investors investing into startups
▪ “Angel Tax”, or a tax on investments by domestic investors, is not taxed anywhere
else in the world
▪ Instead of taxing such receipts, startup investments are incentivised:
 UK - Seed Enterprise Investment Scheme (SEIS)
 US – Section 1202
 Singapore – Angel Investment Tax Deduction Scheme (AITD Scheme)
▪ No concept of valuation for startup investments, only exits and transfers
▪ High share premia is an outcome of valuation and has not been flagged as an
issue of concern anywhere else in the world
▪ Prevention of unaccounted funds coming into startups is solved by:
 Accredited Investor concept
 Stringent AML and KYC
 Bank transfers for all investments
15

16. Accredited Investor - Introduction
▪ Accredited Investor is a means to ascertain
sophisticated investors
▪ Only such investors can invest in risky asset
classes like startups, venture capital funds,
hedge funds, etc
▪ Self certified on the basis of minimum net
worth or income criteria
▪ Investor protection measures like registration
of securities, etc not applicable to them
16

17. Accredited Investor - Criteria
Criteria USA Singapore UK
Net Worth USD 1 Million SGD 2 million GBP 250,000
Income USD 200,000 SGD 300,000 GBP 100,000
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▪ Other criteria include compliance with AML
regulation KYC, FATCA, CRS, UBO (Annexure 2)
▪ All investments via bank transfers
▪ Declaration stating that the investor understands the
risks of investing in such assets is also procured
▪ AML: Anti Money Laundering
▪ KYC: Know your Customer
▪ FATCA: Foreign Account Tax Compliance Act
▪ CRS: Common Reporting Standard
▪ UBO: Ultinate beneficial ownership

18. Valuation Reports Worldwide
▪ Valuation reports for investments into
startups are not mandatory or applicable in
startup ecosystems across the world
▪ Even valuation expert Aswath Damodaran
stated that the “absence of operating history”
and that most startups “do not make it
through these early stages to success” make
valuations difficult
▪ Valuation reports only applicable during exits
or transfers
18

19. 19
Remedial Measures

20. Types of cases afflicting Indian
entrepreneurs
Short Term:
▪ Private limited companies who have received
assessments orders in the past and are
appealing it
▪ Private limited companies who have received
assessments orders in 2018 and are going to
appeal
Long Term:
▪ Companies who have raised capital recently
and are liable to notices under this section 20

21. 21
Short Term Measures

22. 1. Companies who have received “angel tax” assessment
orders in previous years or 2018 and have filed/going to file
an appeal
CBDT circular to be issued stating the following:
 Initial deposit of 20% to obtain a stay to be waived
 No coercive measures or deposits for appealing the
orders
 Valid valuation reports to be accepted and not
disregarded/compared with performance/no change in
valuation methods
 If a SEBI registered VC Fund has invested at the same
valuation, the case should be dropped
 PAN of all investors to be filed by January 30th, 2019 and
other details in the proposed format (Annexure 3)
 Time barred closure of assessment by March 31st, 2019
Draft circular attached in Annexure 4
22

23. 23
Long Term Measures

24. Repeal section 56(2)(viib)
and the link between
section 68 and section
56(2)(viib)
24

25. OR
1. In the upcoming budget, the following modifications to section 56(2)(viib) and
section 68 to be added:
1. Investments received by a private company from resident investors upto Rs 10Cr per year to be
exempt from section 56(2)(viib) and 68 as a class of people notified by the Central Government
2. For investments above 10Cr into private companies, Accredited Investors’ investments should
be exempt from section 56(2)(viib) and section 68 along the lines
3. If an investment is made by a SEBI registered VC Fund, section 56(2)(viib) should not apply for
that capital raise
2. Valuation report for investments by accredited investor and VC funds not
applicable
3. Valuation reports prepared by Approved Valuers under the Company’s Act, 2013
cannot be disregarded
4. Link between exemption under section 56(2)(viib) and 80-IAC to be separated so
that section 56(2)(viib) exemption can apply to a larger number of startups*
5. Committee formed by DIPP to review all open cases and give approvals as
required to settle the matter beyond doubt
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*Section 56(2)(viib) exemption only applies to “eligible startups” defined as startups incorporated after April 1, 2016 and
registered with the DIPP and in receipt of the IMB approval. But the startups facing the angel tax issue is for AY 16-17, ie,
FY 15-16 and were incorporated prior to April 1, 2016

26. DIPP Committee
▪ DIPP proposed a committee of academics to assess the process of
valuation & fundraising of startups
▪ This should have industry representation from prominent domestic
investors
 These domestic to recuse themselves for any investments in which they are
interested
▪ Due to large numbers, best to look at the broad parameters of the
process of getting the valuation report, theme of the startup
▪ For all startups undergoing appeals or those who have assessments
orders should be the first applicants to this committee
▪ The recommendations of this committee should be accepted by the CBDT
▪ We request that the committee not evaluate these companies with the
benefit of hindsight and compare performance to projections
26

27. Accredited Investor
▪ Accredited Investor to be introduced bearing:
 Gross Total income above Rs 25 lakhs for the past 3 years, or
 Net Worth of Rs 1 Crore or
 At least 25% of assets in financial investments
▪ Norms can be laid by DIPP/SEBI/FinMin and applicable for all investments
▪ All Accredited Investors can register with NSDL/CDSL/any authorised
depository
▪ A declaration to the same should be self attested and a report certified by
a chartered accountant, along with the PAN, should be submitted
▪ Accredited investor registration to be done along the lines of investments
into AIFs or Mutual Funds:
 KYC/FATCA/CRS/UBO information to be filed
27

28. Accredited Investor
▪ The budget 2012 memo stated that the newly
introduced measures would not apply when the
“shareholder is a well regulated entity, ie, a VC Fund
registered with SEBI”
▪ Thus for Accredited Investor, regulated by SEBI,
section 56(2)(viib) should not apply and a Central
Government notification classifying Accredited
Investors as a class of persons to whom section
56(2)(viib) and section 68 should not apply.
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29. Conclusion
▪ Domestic funding is only 10% of all capital raised by Indian
startups
▪ 56(2)(viib) was added to prevent laundering of unaccounted
funds, but after the other stringent measures released
(Annexure 5), it has now come to represent a draconian
measure used to harass startups
▪ Measures like the angel tax are causing Indian entrepreneurs
to incorporate businesses in Singapore/USA to operate in
India
▪ Domestic investors need to be incentivised otherwise India
risks becoming a digital colony
29

30. 30
- Honourable Prime Minister Narendra Modi

31. 31
Thank you for being
part of this
movement!
Special thanks to:
S Krishnan
Harish HV &
3one4 Capital

32. 32
Annexures

33. Anx 1: Bare Act:
▪ where a company, not being a company in which the public
are substantially interested, receives, in any previous year,
from any person being a resident, any consideration for issue
of shares that exceeds the face value of such shares, the
aggregate consideration received for such shares as exceeds
the fair market value of the shares:
▪ Provided that this clause 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
 (ii) by a company from a class or classes of persons as
may be notified by the Central Government in this behalf.
33

34. Anx 1: Bare Act:
▪ Explanation.—For the purposes of this clause,—
▪ (a) 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 9; or
 (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;
34
9 Rule 11ua(2) prescribes Book Value method or Discounted Cash Flow method, given by a
Category I Merchant Banker or a chartered accountant (removed from April 1, 2018)

35. Anx 2.a: Singapore: Accredited
Investor
In Singapore, Accredited Investor is defined in Section 4A(1)(a) of the Securities and
Futures Act (SFA), Chapter 289:
▪ Net Personal assets exceeding SGD 2 million (or equivalent in foreign currency).
Or
▪ Income in preceding 12 months of not less than SGD 300,000 (or equivalent in
foreign currency). Or
▪ A corporation with net assets exceeding $10 million in value (or its equivalent in a
foreign currency) or such other amount as the Authority may prescribe, in place
of the first amount, as determined by — (A)the most recent audited balance-
sheet of the corporation; or (B)where the corporation is not required to prepare
audited accounts regularly, a balance-sheet of the corporation certified by the
corporation as giving a true and fair view of the state of affairs of the corporation
as of the date of the balance-sheet, which date shall be within the preceding 12
months;
▪ The trustee of such trust as the Authority may prescribe, when acting in that
capacity; or
▪ Such other person as the Authority may prescribe 35

36. Anx 2.b: United States of America
: Accredited Investor
In the United States, to be considered an accredited investor, one must have
a net worth of at least $1,000,000, excluding the value of one's primary
residence, or have income at least $200,000 each year for the last two years
(or $300,000 combined income if married) and have the expectation to make
the same amount this year. The term "accredited investor" is defined in Rule
501 of Regulation D of the U.S. Securities and Exchange Commission (SEC) as:
▪ a bank, insurance company, registered investment company, business
development company, or small business investment company;
▪ an employee benefit plan, within the meaning of the Employee
Retirement Income Security Act, if a bank, insurance company, or
registered investment adviser makes the investment decisions, or if the
plan has total assets in excess of $5 million;
▪ a charitable organization, corporation, or partnership with assets
exceeding $5 million;
36

37. Anx 2.b: United States of America
: Accredited Investor
▪ a director, executive officer, or general partner of the company selling the
securities;
▪ a business in which all the equity owners are accredited investors;
▪ a natural person who has individual net worth, or joint net worth with the
person's spouse, that exceeds $1 million at the time of the purchase, or
has assets under management of $1 million or above, excluding the value
of the individual's primary residence;
▪ a natural person with income exceeding $200,000 in each of the two most
recent years or joint income with a spouse exceeding $300,000 for those
years and a reasonable expectation of the same income level in the
current year; or
▪ a trust with assets in excess of $5 million, not formed to acquire the
securities offered, whose purchases a sophisticated person makes
37

38. Anx 2.c: European Union :
Accredited Investor
Retail clients requesting treatment as 'elective' professional clients (as
defined by Markets in Financial Instruments Directive (MiFID)) must satisfy at
least two of the following quantitative criteria in assessing the client's
expertise, experience and knowledge:
▪ the client has carried out trade transactions, in significant size (at least
EUR 50,000), on the relevant market at an average frequency of 10 per
quarter over the previous four quarters;
▪ the size of the client's financial instrument portfolio, defined as including
cash deposits and financial instruments, exceeds EUR 500,000;
▪ the client works or has worked in the financial sector for at least one year
in a professional position which requires knowledge of the transactions or
services envisage
38

39. Anx 3:Format of submission by
startups
39
Name of
the
Investor
Structure of Investor
(Individual, HUF,
Trust, , company,
partnership, VC Fund,
others)
Date of
Receipt of
funds
Number of
Shares
Subscribed
To
Face
Value of
Shares
Premium
of Shares
Address
of
Investor
Email ID of
Investor
Residence
Status of
Investor
PAN
(Residents) /
UIN from
SMF/FCGPR
(Non –
Residents)
Mode of
Receipt of
Funds (Bank
transfer,cash)

40. Anx 4: Draft Circular
40
MINISTRY OF FINANCE
(Department of Revenue)
(Central Board of Direct Taxes)
NOTIFICATION
New Delhi, the date xxxx 2019
INCOME-TAX
S.O. XXXX(E).—In exercise of the powers conferred by the clause (ii) of the proviso to clause
(viib) of subsection (2) of section 56 of the Income-tax Act, 1961 (43 of 1961) and in
supersession of the notification number S.O.2088(E) dated 24th
May, 2018 issued by
Department of Revenue, Central Board of Direct Taxes, the Central Government, hereby
notifies that the provisions of clause (viib) of sub-section (2) of section 56 of the said Act shall
not apply to
1. the consideration received by all Startups recognised by the Department of Industrial Policy
and Promotion as a Startup.
2. consideration received by all other companies:
(i) if they are proposing to issue securities to investors having an average income of Rs. 25
lakhs or more for the preceding three financial years (as per filed income-tax returns),
and net worth of Rs. 2 crores or more as on the last date of the preceding financial year,
and
(ii) has obtained a report from a merchant banker or a chartered accountant specifying the
fair market value of shares in accordance with Rule 11UA(2) of the Income-tax Rules,
1962.
Other companies would refer to companies who are not recognised as a Startup by the
Department of Industrial Policy and Promotion but having a turnover of less than Rs. 25 crores
for any of the financial years since incorporation/ registration upto a period of seven years
from the date of incorporation/ registration and who have issued shares at a premium during
this tenure. In the case of companies in the biotechnology sector, the period shall be upto ten
years from the date of its incorporation/ registration.
It is hereby clarified that the Fair Market Value certified by the merchant banker shall be
accepted by the income tax authorities as a true and fair valuation.
2. This notification shall be deemed to have come into force retrospectively from the 17th
February, 2016.
[Notification No. xxxxx]
XXXXXX, Director (Tax Policy and Legislation)

41. Anx 5:Company’s Act Measures
for plugging unaccounted funds
▪ All capital raised by a company needs to come in via bank transfers, with
the bank account from which the investment is made being intimated to
the company (Rule 14, Companies (Prospectus and Allotment of
Securities) Rules,2014)
▪ Private placement and preferential allotment forms need to name the
investor and such forms cannot be transferred to anyone else (Rule 14,
Companies (Prospectus and Allotment of Securities) Rules,2014)
▪ PAN of the investors needs to be mandatorily filed with the Company
(Rule 14, Companies (Prospectus and Allotment of Securities) Rules,2014)
▪ All raise documents need to be filed with the RoC for the raise to be valid
▪ Beneficial ownership to be declared within 30 days of an investment
(Companies (Significant Beneficial Owners) Rules, 2018)
41