Understanding 'Start-Up Tax'

Start-Up Tax, and the policy conundrum related to it, explained with the example of Tehelka

The National Democratic Alliance (NDA) government is contemplating a proposal to exempt start ups from service tax and excise duty for a specified period (Economic Times report, 5 February).  Assuming that this proposal will see the light of the day in the coming Budget, it is a welcome initiative. The present tax structure of our country is such that start-ups are required to pay taxes even before they break even. Granting a specified period of exemption from service tax and excise duty will be one leap in addressing this issue.

Start-ups should be exempted from the Minimum Alternate Tax (MAT) and yet another provision unofficially referred to as the start-up tax or “angel tax” for a specified period.  Granting exemption from these two taxes will wholly address complexities faced by start-ups. The Business Standard has reported that the MAT rate is likely to be revised in the forthcoming Budget as the government is focusing on promoting the ‘Make In India’ initiative. The current rate of MAT is 18.5 per cent excluding surcharge and cess and this rate is uniform for all sectors. Going by the news report, it seems the government may introduce differential rates of MAT for each sector and the MAT rate for MSME and Infrastructure sectors will be minimal.

However, until now, there seems to be no buzz about the start-up tax. Whether start-ups  will be exempted from this tax or not is still unknown. The demand to exempt start-up companies from this tax has been pending for quite a long time, troubling entrepreneurs more than the service tax, excise duty or MAT.

Harsh Vora in his article, “This is No Way to Make Business Easy,” has given a decent introduction about this start-up tax: how it affects the investment climate and how this tax is forcing start-ups to shift their base to foreign tax havens. Finally, he has also suggested that this tax has to be purged if the government is serious about accomplishing its goal of improving the investment and business climate.

However, removing this tax will do no good either because the start up tax is not just restricted to start up companies.

We need to go by the name specified in The Income Tax Act, 1961, and not by its unofficial name. The name given by the Act is “tax on premiums received in excess of Fair Market Value (FMV) of the shares”.  The purpose for introducing this tax can be better understood with the help of a case on Tehelka.

Anant Media Pvt. Ltd., the publishing house of the weekly magazine Tehelka, was incorporated on 21 August 2003 with a handful of shareholders. Despite the fact that this weekly magazine was well received by the public, the company was continuously incurring losses. For the year 2011-12 the financials of the company indicated a negative networth of Rs 13 crores. Thus, even nine years after its incorporation, it not only continued to suffer negative returns but had actually burnt cash. Pragmatically speaking, a company which continued to incur losses for most of its existence will never have the luxury of having investors investing in the stocks of the company for a premium. But Anant Media proved otherwise. It made a killing by issuing shares for an exorbitant premium, re-purchasing it for face value and then re-selling them for a ridiculous premium once again.

In 2006 Tarun Tejpal and his family members offloaded a part of their stakes at Anant Media while Shoma Chaudhury offloaded her entire stake. The shares were sold for an exorbitant premium of Rs 13,189 per share. The face value of these shares was Rs 10. Needless to say, they made huge profits by diluting their stakes. However, the accounting books recorded continuous losses for most of the financial years.

Hence, the FMV of the shares would have been even lesser than Rs. 10. Even if one were to say, the investor/ buyer bought the shares for such a huge premium in consideration of its future business potential, it would still be an exaggeration. Such a huge premium for a loss making entity is by no means justifiable. Who is that investor that chose to buy the shares at such a huge premium? It is a company named AK Gurtu Holdings which, going by the reports of Indian Express, is indirectly owned by industrialist and former Congress MP Naveen Jindal.

In 2007, all the shares of Anant Media that were remaining with AK Gurtu Holdings were bought back for Rs 10. Later, A K Gurtu Holdings was renamed as “Enlightened Consultancy Services” and then in 2008 the same number of shares were re-issued to “Enlightened Consultancy Services” and “Weldon Polymers”. This time it was issued for a premium of Rs. 10,263. Weldon Polymers too, is indirectly owned by Naveen Jindal.

In 2009, Anant Media bought back 6534 shares from Weldon Polymers and yet again, for a face value of Rs 10. It was  reissued to Royal Building and Infrastructure, owned by KD Singh present Rajya Sabha MP from TMC, for a premium of Rs 2,505.

In December 2011, once again Anant Media issued 1,01,371 shares to Royal Building and Infrastructure for a premium of Rs 2505 thereby, making Royal Building and Infrastructure  the majority shareholder of Anant Media.

The Indian Express report stated that in return for the first tranche of funding (disguised as share premium) made by Weldon Polymers to Anant Media, Tehelka published a two-page report titled “Friendly Deception” in which it alleged that Arvind Sharma (former Karnal Congress MP) has defrauded Naveen Jindal and is also attempting to frame Naveen Jindal in a false case.

Let us observe these transactions from a taxman’s perspective. Naveen Jindal’s companies invested in Anant Media with a clear motive of funding it in the form of share premium. Later Jindal’s companies surrendered the shares to Anant Media for face value resulting in huge losses. This pattern of making investments at huge premiums and exiting at losses can be observed not once but thrice. Assuming that all the transactions with Anant Media are genuine, just try to answer one simple question.  Will any wise businessman, after his prior experience with Anant Media, opt to invest once again in the same company for an exorbitant premium?

The following conclusions can be drawn from the aforementioned investment transactions:

1. Jindal’s companies invested in Anant Media with a clear intention of making losses.
2. Tehelka received money from Jindal’s companies as an investment, but owing to the exorbitant premium, one can conclude that it is not a genuine investment.
3. Tehelka enjoyed the share premium money it received, from Jindal’s companies not once but thrice.

It’s clear that the share premium here, is the money intended for some other purpose. It could be for carrying an article that portrayed Naveen Jindal as a gullible victim or perhaps,  for not carrying an adverse article about him/ his companies or maybe simply because Jindal chose to keep funding Tehelka through the share premium route given its known pro-Congress-anti-BJP stand.  Instead of giving the money as share premium, Jindal could have opted to advertise his companies in Tehelka in return of an “advertisement fees” to Tehelka (Anant Media). Why did he not do that? Why did he choose the “share premium” route over other ways of funding? The answer is simple.

Had he chosen any other route for funding Tehelka, a well informed reader could have identified the nexus effortlessly. Moreover, there would be no proper justification for receiving such an exorbitant amount as “advertisement fees” given that the advertisement charges levied by other similar English magazines will be less thereby, raising doubts. Further, assuming that such a hefty advertisement income would have brought Tehelka’s books to profits, it would have attracted taxes.

By disguising the money as “share premium”, Tehelka was not required to pay taxes as there was no provision in the Income Tax Act at that time, under which “share premium” could be taxed. From taxman’s point of view, “share premium” here, is actually an income on which the tax department is losing taxes. Also, for Jindal’s companies, its investment in Tehelka (Anant Media)  has resulted in a heavy loss. This loss can be set off against the profits of any other present/ future investments (subject to certain conditions). On one hand, under the guise of “Share Premium”,  hidden income is being received by Tehelka without paying any taxes on it, while on the other hand, Jindal’s companies, by purposefully investing at an exorbitant premium with a specific intention of making losses as well as funding Tehelka, use this route as a tax saver. Thus, the income tax department is losing “tax” on not just one but two sources.

The case of Tehelka is just a tip of an ice berg. There are numerous companies which use this share premium route for receiving income. Hence, with the intention of bringing these kinds of dubious transactions under the tax net, start up tax, which is “tax on premiums received in excess of Fair Market Value (FMV)of the shares” was introduced. If the start up tax were to be purged then the “dubious transactions” as explained in the above case will go untaxed.

But there is a complex problem here. On the one hand, because of this start-up tax even a genuine startup company that seeks investment from an “angel investor” for a premium is being forced to pay taxes but if this tax were to be purged/ scrapped then there is a possibility of income escaping the tax net in the guise of a share premium.

Hope with all my best efforts I managed to make the readers understand the basic concept of start up tax and why it was introduced. I don’t want to burden them with anymore additional information/ analysis for now. My next article will carry a detailed analysis on the provisions of start- up tax as given in Income Tax Act and the manner in which this tax affect the start-up companies. Most importantly it will also carry my views on what can be done to address the above mentioned complex problem.