In a major ruling that will have a profound impact on the way companies are taxed, the Income Tax Appellate Tribunal [ITAT] has upheld the validity of the discounted cash flow [DCF] method for arriving at the fair market value of a company’s share. The order says “the DCF method is a recognized method though it is not an exact science and can never be done with arithmetic precision”.
The order needs to be viewed in the backdrop of the tax demands raised on hundreds of companies [besides assessment notices on thousands of them] issued by the Income-Tax [IT] department for payment of tax on the extra capital raised through the issue of shares over and above their fair market value [FMV]. These included notices on hundreds of start-ups – a euphemism for unlisted firms which turn ‘innovative idea’ in to attractive business venture. The tax on these companies is tantalizingly termed as ‘angel tax’.
The demands were raised under Section 56 of the I-T Act [1961] treating excess capital so raised [excess of the purchase price over FMV] as ‘income from other sources’. The most crucial determinant of the tax liability is FMV. If, it is high, the tax levied will be less. On the other hand, if it is low, the tax will be high.
The I-T department questioned the high valuations that were based on future [albeit inflated] projections about the likely performance of the company. It averred that by inflating the FMV and thereby deflating the excess capital, the firms were intending to minimize the tax outgo. The department had reason to suspect as ‘how come an entity suffering losses in the present could command high valuations’?
On a close look, it turns out that the real culprit was the DCF method which provides enough room for maneuvering and gives legitimacy to such inflated projections. No wonder, the department decided not to take a look at it and instead opted for more realistic basis for determination of the FMV. Unfortunately, doing a volte face, the ITAT has upheld the validity of using DCF.
The Tribunal has ruled that just because the taxman has “hindsight” view doesn’t mean that the projections were inaccurate. ‘The fact that future projections of various factors made by applying hindsight view cannot be matched with actual performance does not mean that the DCF method is not correct’.
The judicial authority recognizes that actual numbers do not match with projected values yet if it has upheld the DCF method, this will be a big set-back for the I-T department. The companies will continue to get away with high valuations and resultant high premium [in many cases, despite incurring losses year-after-year] thereby denying the revenue department its legitimate dues.
Already, following a hue and cry, the government has given huge relief to start-ups. The measures announced by the commerce ministry include (i) increase in the funding limit by unlisted firms and individuals in a start-up to be exempted from the angel tax from the current Rs 10 crore to Rs 25 crore; (ii) no such limit for investments by listed firms with net-worth above Rs 100 crore or turnover of Rs 250 crore; (iii) relaxing the criteria for start-ups from current 7 years to 10 years and turnover limit from existing Rs 25 crore to Rs 100 crore.
Henceforth, a start-up fulfilling the above criteria needs to submit ‘memorandum of information’ to the department for promotion of industry and internal trade [DPIIT] in the commerce ministry who after confirming the eligibility, will communicate to Central Board of Direct Taxes [CBDT]. The CBDT in turn, will ensure exemption of the concerned entity from angel tax.
The above liberalization [albeit substantial] of norms for the investors as well as the start-up firms have ensured that an overwhelming number of them go out of the tax net. This includes those who have already been served with tax demand. Those notices will be withdrawn of course, following the due process of law.
With ITAT order, even firms other than start-ups [besides a few unfortunate ones who might suffer due to exercise of discretion by the bureaucrat to disallow exemption even in this category] will be able to escape payment of tax as the DCF method cannot be rejected by the taxman routinely.
This brings us to the genesis of the tax on excess capital raised by start-up or any other entity. When, an investor pays an amount in excess of its FMV [or premium], this is as good as profit/income in the hands of the firm. In case however, the premium is exceptionally high having no relationship whatsoever to the fair value, it raises eyebrow. It points towards unaccounted cash or black money being funneled in to the corporate entities.
This fundamental point can’t be brushed aside simply because the recipient of the laundered money happens to be a start-up – firms which offer huge potential and are crucial to a rising India. Apart from revenue consideration, taxation of the premium amount should also be viewed as an instrument of reining in black money.
While, there can be no two opinions on the overarching need to ensure increase in funding for start-ups, the government must not do anything which compromises on its fight against black money. This will also be in sync with Modi’s philosophy of ‘zero tolerance’ for corruption and black money.
Viewed in this much broader perspective, the I-T department should challenge the order of the ITAT at higher level in the judicial forum. Concurrently, the government should also take a re-look at the package offered by DPIIT. It must refrain from giving the start-ups blanket exemption from levy of angel tax.