While there can be no two opinions on the overarching need to increase funding for start-ups, the Government must not do anything which compromises its fight against black money. The DCF valuation method is not sustainable and must be challenged

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 recognised; 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 tax demands raised on hundreds of companies by the Income Tax (IT) department for the payment of tax on the extra capital raised through the issue of shares over and above their Fair Market Value (FMV). These included notices for the so-called “angel tax” to start-ups — a euphemism for unlisted firms which turn ‘innovative ideas’ into attractive business ventures. Demands were raised under Section 56 of the Income-tax 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, tax will be high.

The department questioned the high valuations that were based on future projections about the likely performance of the company. It averred that by inflating the FMV and thereby deflating excess capital, firms were intending to minimise the tax outgo. The taxman had reason to suspect as how come an entity suffering losses in the present could command high valuations?

On a closer look, it turns out that the real culprit is the DCF method, which provides room for maneuvering. Accordingly, the IT department decided not to look at it and instead, opted for a more realistic basis for determining the FMV. But the Tribunal does not agree. It has ruled “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 Tribunal recognises that actual numbers do not match with projected values and yet, it upholds the DCF method, which acts as a springboard to inflated FMV. This is anomalous and will be a big setback to the taxman. 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, the Government has given huge relief to start-ups by (i) increasing 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) setting no such limit for investments by listed firms with net worth above Rs 100 crore or turnover of Rs 250 crore and (iii) relaxing the criteria for start-up from current seven 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 a “memorandum of information” to the Department for Promotion of Industry and Internal Trade ([DPIIT) in the Ministry of Commerce and Industry, who after confirming eligibility, will tell the Central Board of Direct Taxes (CBDT) to notify exemption of the concerned entity from the angel tax.              

The liberalisation of norms has ensured that an overwhelming number of start-ups goes out of the tax net. With the ITAT order, even firms other than start-ups (besides a few unfortunate ones on whom the bureaucrat in the Commerce Ministry may not shower his/her benevolence) 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 the 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 receiving firm. In case, however, the premium is exceptionally high, having no relationship whatsoever to the fair market value, it raises eyebrows. It points towards unaccounted cash or black money being funnelled into 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 an increase in funding for start-ups, the Government must not do anything which compromises its fight against black money. This will also be in sync with Prime Minister Narendra Modi’s philosophy of “zero tolerance” for corruption and black money.

Viewed in this much-broader perspective, the IT department should challenge the order of the ITAT at higher levels in the judicial forum. Concurrently, the Government should 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.

(The writer is a New Delhi-based policy analyst)