Introduction :

Shark Tank: The Angle Investor

Shark Tank the popular reality TV show where entrepreneurs pitch their business ideas to a panel of investors, also known as“Sharks”. The sharks are successful business people who are willing to invest their own money in promising startups.

But what goes on behind the scenes of Shark Tank? How do the companies that receive investments deal with the taxation of those investments?

The tax implications of receiving an investment from a shark can be complex, but it is important for any entrepreneur who appears on the show to understand them. By understanding the tax implications, entrepreneurs can make informed decisions.

Let's get a better understanding of this.

Who are Angel Investors and what is angel tax?

Angel investors are high-net-worth individuals who use their personal wealth to invest in startups orsmall businesses in exchange for equity ownership. "Sharks" therefore fall under the category of “Angel investors”.

Becoming an angel investor, as per SEBI guidelines, isn't open to everyone. To qualify as an angel investor, one must have net tangible assets of at least 2 crore rupees (excluding their principal residence) and must invest a minimum amount of Rs.25 lakhs. Additionally, they should meet at least one of the following criteria: possess early stage investment experience, be a serial entrepreneur, or have a minimum of ten years of senior management experience. These requirements ensure that Angel Investors are well equipped to support and guide startups effectively.

Angel Tax islevied as perthe Finance Act of 2012, which is an amendmentto the Income Tax Act. It applies to unlisted startup companies that receive funding from angel investors exceeding the fair market value of the shares issued by the company. In this scenario, the startup is required to pay a designated amount to the government, referred to as Angel Tax.

Example: Suppose a startup A Pvt Ltd has managed to receive an investment of Rs 10 crore by issuing 1 lakh shares to an Indian investor at Rs 1000 each. The startup's fair market value is Rs 700 per share. Henceforth, the fair market valuation of shares stands at Rs 7 crore. Then the startup needs to pay angel tax on the excess of fair market value, which is Rs 3 Crore (Rs 10 crore - Rs 7 crore). As a result, the amount of tax due on this transaction will be Rs 92,70,000 (i.e., 30.9% on Rs 3 Crore).

Listed and Unlisted companies

What are listed companies?

These are companies that raise capital from the public by listing themselves on the stock exchanges like National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE). This enablesthe companiesto secure funds for expansion, debt repayment, or strategic needs. The listing process requires the companies to produce extensive and detailed documentation and comply with the stipulated regulations. Listed companies usually have a large number of shareholders and there is liquidity to buy or sell shares easily as they are listed on the stock exchange.

What are Unlisted Companies?

These companies are not listed on any stock exchanges and owned by private investors (maybe angel investors). An unlisted company cannot raise capital from the general public and usually depends on the owners for all its capital requirements. On the other hand, an unlisted company do not have any stringent documentation process and they benefit from the ownership structure which facilitates easy decision making.

Many startup companies start as unlisted entities and, after establishing a foundation, opt to go public by getting listed on stock exchanges. This transition enables them to raise capital for expansion and gain recognition.

Par value, fair market value and book value

The face value of a share is a nominal value assigned to each share by the company when it initially issues its shares. This value is recorded in the company's books and on the share certificates. It's essentially the legal or accounting value of the share. The face value of a share typically remainsfixed unlessthe company decides to take actions like a share split.

The fair market value for a listed company is the real-time price at which a company's shares are traded on the stock market. The fair market value for an unlisted company represents what a single share of stock would be worth on the open market .It is calculated by analyzing the assets worth, present value of future cash flows, comparing prices with other similar companies.

The book value is calculated by deducting a company's intangible assets (like patents and goodwill) and liabilities from its total assets. This resulting figure is then divided by the total number of outstanding shares, yielding the book value per share. This metric reveals the tangible value associated with each share, considering a company's asset base and financial obligations.

Understanding 56(2)(viib) for Investment taxation:

Based on the explanations provided above, it's clear that when a resident investor invests in an unlisted company in exchange of unquoted shares of any type and the amount contributed exceeds the fair market value, the surplus is treated as the company's income and the provisions of Sec 56(2)(viib) are attracted. This income is categorized under "Income from Other Sources" for taxation purposes, which is distinct from business income or capital gains. These tax provisions apply only when the funds come from sources other than venture capital funds or specific groups of investorsidentified by the Central Governmentsuch as entity controlled by the government.

In order to compute tax and to arrive at the fair market value of shares for the consideration received from investors, Rule 11 UA (2) is the Key.

Rule 11UA (2)

Rule 11UA(2) of the Income Tax Act, 1961 deals with the valuation of unquoted shares being unquoted equity shares and compulsorily convertible preference shares (CCPS) in a company which are not listed in any recognized stock exchange.

It states that the fair market value of unquoted shares and securities is to be determined based on the price that it would fetch if sold in the open market. The assessee may obtain a report from a merchant banker or an accountant to determine the fair market value. It is important to note that there is no single formula that can be used to determine the fair market value in all cases. The selection of formula depends on factorssuch as Industry of the company, financial health of the company, future growth aspect of the company and so on. Two widely employed methods for valuing unquoted shares, commonly used by unlisted companies, are the Book Value Method and the Discounted Cash Flow Method. In this process, companies have the flexibility to opt for either a merchant banker or a valuation officer to accurately compute the fair market value. This flexibility ensures that companies can select the most suitable approach for assessing the worth of their shares, facilitating fair and accurate taxation in compliance with regulatory requirements.

Until 2023, these tax provisions applied exclusively to contributions from resident investors. However, a significant change came into effect when CBDT notified a circular in the 2023 Finance Bill. This change expanded the scope of Section 56(2)(viib) to include contributions from non-resident investors as well. Consequently, any excess amount over the fair market value of such contributions will now be subject to taxation. Ensuring that both resident and non-resident investors are subject to the same taxation rules regarding contributions exceeding fair market value.

The amendment also introduces a few other methods for fair market valuation which now extend to even compulsorily convertible preference shares (CCPS).These include:-Comparable Company Multiple Method, Probability Weighted Expected Return Method, Option Pricing Method, Milestone Analysis Method and Replacement Cost Methods. Previously, these methods were only used for the valuation of unquoted equity shares.

As per the amendment,Section 56(2)(viib) also covers consideration from non-resident companies notified by the Central Government for valuation under Rule 11 UA(2), subject to the conditions that the share price corresponding to the consideration can be considered as Fair Market Value (FMV) and that the consideration from the notified entity must be received within 90 daysfrom the date ofshare issuance subject to valuation.

Additionally, an essential provision introduced is the "Safe Harbor Limit" set at 10% for the valuation of shares, applying to both resident and non-resident investments.

Conclusion:

Understanding the intricacies of investment taxation is crucial, especially in scenarios like those seen on the popular TV show "Shark Tank," where entrepreneurs seek investment from successful business individuals, or "Sharks."

A significant aspect is understanding the provisions of Section 56(2)(viib), which impact the taxation of investments exceeding the fair market value of shares. Furthermore, as of 2023, these provisions are no longer exclusive to resident investors but also include non-resident contributors. This understanding of investment taxation is crucial for making informed decisions and complying with tax regulations when seeking investments or investing in startups and unlisted companies.