Startups in India play a pivotal role in the economy by driving innovation, creating jobs, and contributing to overall growth. However, raising capital through share premiums has often drawn scrutiny under Section 56(2)(viib) of the Income Tax Act, 1961, which seeks to curb the use of inflated premiums for money laundering. Despite the stringent provisions, the government introduced the Start-Up India Scheme to provide tax benefits to genuine startups raising funds through share premiums. A significant procedural requirement under the scheme is the filing of Form 2 with the Department for Promotion of Industry and Internal Trade (DPIIT).
This article examines the legal framework under Section 56(2)(viib), the importance of Form 2 filing, judicial precedents, and how these elements impact the taxation of share premiums for startups. We will explore decided cases, CBDT circulars, and DPIIT notifications to offer a comprehensive perspective on how the law interprets procedural compliance and the allowability of share premiums in the case of startups.
Revised Analysis of Section 56(2)(viib) and Form 2 Filing for Startups with Judicial Precedents
I. Introduction: Section 56(2)(viib) and Share Premiums for Startups
Section 56(2)(viib) of the Income Tax Act, 1961, seeks to prevent the issue of shares at an inflated premium, often used to introduce unaccounted money into the financial system. The section stipulates that when a private company issues shares at a premium that exceeds the Fair Market Value (FMV) of the shares, such excess premium is treated as income. However, for startups, which may issue shares based on potential rather than current performance, the law provides exceptions—provided that the premium is reasonable and substantiated by a valuation report from a registered valuer.
To streamline this process and ensure legitimate capital raising, the government introduced the Start-Up India Scheme and associated procedural requirements, including the filing of Form 2 under the scheme. This filing serves as a declaration that the startup adheres to the conditions set out under the scheme, including being recognized by the Department for Promotion of Industry and Internal Trade (DPIIT).
II. Procedural Compliance: Form 2 Filing under CBDT Circulars
Under the Start-Up India Scheme, Form 2 must be filed to declare that a startup qualifies for exemptions under Section 56(2)(viib). Filing this form with DPIIT is crucial for ensuring that the share premium is not treated as income under the provisions of the Income Tax Act. This filing, along with a valuation report, substantiates the legitimacy of the capital raised through share premiums.
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Eligibility: The company must meet the DPIIT’s criteria for a startup and must be recognized as such.
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Procedure: The startup must file Form 2 with the DPIIT, declaring compliance with all eligibility requirements.
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Valuation: The valuation report must confirm that the share premium does not exceed the FMV of the shares.
III. Judicial Precedents: Review of Cases in Favor of Assessees
1. Idana Pet Industries Pvt. Ltd. v. ITO (ITA No. 150/Jodh/2017) – Jodhpur ITAT
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Citation: [2017] ITA No. 150/Jodh/2017
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Facts: The assessee issued shares at a premium, but the AO questioned the premium as excessive, especially since Form 2 had not been filed. The startup, however, supported the premium with a valuation report from a registered valuer.
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Judgment: The ITAT ruled that the share premium was justifiable and, despite the non-filing of Form 2, the premium was not to be treated as income under Section 56(2)(viib). The court recognized the substance of the transaction and found no evidence of malfeasance.
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Reasoning: The tribunal emphasized that procedural lapses like the failure to file Form 2 should not automatically invalidate genuine business transactions. Substance over form should govern such decisions.
2. Vinayaka Microns India Pvt. Ltd. v. Pr. CIT (2021) 63 CCH 294 (Jaipur-Trib) – Jaipur ITAT
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Citation: [2021] 63 CCH 294 (Jaipur-Trib)
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Facts: The startup raised capital through a share premium, but the AO challenged the premium because the startup had not filed Form 2 with DPIIT. The startup had a valuation report that supported the premium.
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Judgment: The ITAT ruled in favor of the assessee, confirming that the share premium was reasonable based on the valuation report. The court held that non-filing of Form 2 did not invalidate the premium as long as the substance of the transaction was legitimate.
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Reasoning: The court reaffirmed that procedural defaults should not result in automatic disallowance if the FMV of the shares was correctly established. The transaction's genuineness and legitimate business purpose were key factors in the decision.
3. Subhkam Ventures Pvt. Ltd. v. ITO (ITA No. 2256/Del/2019) – Delhi ITAT
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Citation: [2019] ITA No. 2256/Del/2019
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Facts: The startup raised funds through share premiums, but the AO disallowed the premium, citing the non-filing of Form 2. The premium was supported by a valuation report from a registered valuer.
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Judgment: The ITAT ruled in favor of the assessee, finding that the share premium was substantiated by a genuine valuation. The court remanded the case to the AO for clarification, but it confirmed that procedural non-compliance alone could not justify disallowance.
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Reasoning: The ITAT stressed that capital raising through legitimate means should not be penalized due to procedural lapses. The presence of a valid valuation report outweighed the procedural failure to file Form 2.
IV. Relevant Circulars and Notifications
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CBDT Notification 23/2019 – Exemptions for startups recognized under the Start-Up India Scheme.
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Provisions: The notification clarified that startups recognized by DPIIT and meeting other conditions under Section 56(2)(viib) would not face taxation on share premiums if the premium is supported by a valuation report and complies with DPIIT requirements.
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DPIIT Circular 1/2020 – Filing of Form 2 under the Start-Up India Scheme.
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Details: The circular outlines the criteria for Form 2 filing and stresses that a startup must be recognized by DPIIT to claim tax benefits under Section 56(2)(viib).
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CBDT Circular 10/2019 – Clarification on the applicability of Section 56(2)(viib) to startups.
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Clarification: The CBDT stated that startups should comply with both tax and procedural requirements, such as Form 2 filing, for exemption from taxation on share premiums.
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V. Conclusion: Procedural Lapses and Judicial Approaches
While Form 2 is an important procedural requirement for startups under the Start-Up India Scheme, judicial precedents indicate that substance over form should prevail. Courts have consistently ruled in favor of startups where the share premium was based on a genuine valuation and there was no evidence of fraudulent intent, even if Form 2 had not been filed. Procedural lapses, though significant, should not be used as a basis to invalidate legitimate business transactions.
However, to avoid ambiguity and ensure compliance, startups should ensure that Form 2 is filed with DPIIT, along with a valuation report from a registered valuer, to substantiate the share premium and secure the benefits under Section 56(2)(viib).
The CBDT circulars and DPIIT filings provide the necessary legal backing for startups to raise capital through share premiums without facing undue tax burdens, as long as the transactions are genuine and comply with the prescribed procedures.
