The tax department in an overdrive mode has started questioning the valuations of start-up companies inasmuch as the premium received by such companies on issuance of shares is being questioned/challenged by the tax authorities.
It is not the first time that the tax department has targeted a particular class of tax payers. A few years back when India was the leader in providing BPO services, the tax authorities started questioning the BPO’s and went all out to prove that these companies were not rendering IT enabled services. Consequently, the deduction claimed by such companies was denied and huge tax liability was fastened on such companies. What followed was litigation with no benefit to the exchequer. The Government eventually phased out the sections which provided exemption/ deduction to IT enabled services.
Similar is the case with start-up companies. The tax authorities have started rejecting the valuation reports obtained by the start-up companies and stepping into the shoes of the valuer by determining the fair value of the shares. Consequently, the difference between the value determined by the Assessing Officer and the value at which the shares have been issued is being subjected to tax in accordance with section 56(2)(viib) of the Income-tax Act, 1961.
The rules issued for the purposes of valuation provide that the valuation can be conducted either by the net asset value method or the discounted cashflow method. In a start-up company the application of the NAV method may not be possible as most of these companies are technology companies which cannot be valued on NAV basis.
At this juncture, one needs to appreciate the difference between price and value. Value will always be different for different persons whereas price will always be the same for a similar product. Therefore, the value of a start-up for an investor will vary and cannot be compared with the value determined by the Assessing officer. Further, valuation is based on certain datapoints at a given point of time which may change at a later date. Therefore, questioning the valuation of a start- up which is backed by a reasoned valuation report is not justified. Another argument against the action of the tax authorities is that the amount received is on capital account and therefore should not be taxed.
Consider a case where a start-up issues shares at Rs. 150/- per share and collects Rs. 140/- as premium. The tax authorities subsequently challenge the valuation and determine the fair value of the shares at Rs. 40/- per share as a result of which the excess premium of Rs. 110/- is subjected to tax. An innovative tax officer will then take a plea that since Rs. 110/- per share was not towards issuance of capital and has been deemed as income, the cost of acquisition of the share in the hands of the investor should only be Rs. 40/- and not Rs. 150/- thereby taxing the difference once again as capital gain in the hands of the investor as and when the shares are sold by the investor.
I hope that the government takes necessary steps to resolve this issue and promote the start-up movement which is gaining momentum and is essential for the growth of the country.