Explained: How will a recent tax ruling on IPO-bound Oyo affect other startups?

New Delhi, June 17 -- A recent ruling by the income tax appellate authority in favour of hospitality company Oyo, which is preparing to go public, could help a number of startups battling tax demands on capital raised from investors.

On June 4, the Delhi bench of the Income Tax Appellate Tribunal (ITAT) struck down a tax demand on Oyo Hotels and Homes Pvt Ltd for an income of around Rs 3,885 crore, and tax experts say that the ruling could help various startups which are challenging similar tax notices.

Mumbai-listed edtech company Physicswallah, for example, recently received a tax demand for Rs 263.34 crore for the assessment year 2023-24 after tax officials treated money raised from investors as taxable income.

The ITAT's ruling came just as Oyo parent Prism Hotels & Resorts received approval from the Securities and Exchange Board of India for its initial public offering.

What was the Oyo transaction?

Oyo Hotels had issued compulsorily convertible preference shares (CCPS) to its parent Oravel Stays Ltd, now rebranded as Prism, at a share premium of around Rs 3,885.52 crore.

Oyo claimed that this was done after two independent valuers completed a valuation exercise.

The National Faceless Assessment Centre held this share premium as taxable under Section 56(2) (viib) of the Income Tax Act, 1961. This section-widely known as the Angel Tax-covers the taxability of income from shares issued to existing shareholders at a price exceeding the fair market value.

The assessment centre's order was upheld by the National Faceless Appeal Centre. Oyo then appealed to the ITAT.

What was the tax officer's contention?

According to the tax assessing officer, the share valuation had been done based on aggressive projections especially since the company was recording consistent losses at the time of issue of shares.

The net worth of the company in FY20 was a negative Rs 36,663 crore and a negative Rs 376 crore in FY21, and the company was incurring consistent losses from FY19 to FY22. Meanwhile, through two transactions in April and November 2020, a total premium of Rs 3,738 crore had been paid for Oyo's shares.

The officer added Rs 147 crore to the company's income after noting that it had been earned through excess share premium from a transaction done in March 2022. In this transaction, the company had converted a small portion of the CCPS with a face value of Rs 100 each to equity shares with a face value of Rs 10 each and had placed the remaining Rs 90 per share to a securities premium account. According to the officer, this proved that the differential amount had the character of share premium.

The officer questioned the valuation by noting that the data for this was supplied by the company to value the shares at "abnormal prices to manipulate the share prices to get the unfair introduction of capital", and stated that this was in contravention of Section 56 (2) (viib) of the I-T Act.

Given this, the tax officer added the capital raised, to the extent of the share premium, back to Oyo's income to make the additional claim.

Why did the ITAT differ?

The ITAT differed with the assessment officer saying that the company needed this fresh additional capital since this was the only way to get it out of debt, seeing as it was running at consistent losses.

It also pointed out that the value of shares was obtained from the RBI-approved valuers and that, since the valuation was done based on Rule 11UA of the I-T Rules, the tax authorities cannot change the valuation method adopted by the assessee. While the company-appointed valuation experts used the forward-looking Discounted Cash Flow (DCF) method, the tax official had relied on the Net Asset Value (NAV) method that relies on assets.

The order stated: "The tax authorities have gone beyond their jurisdiction in re-evaluation of (the) value of each share even though the same was valued by the registered valuers or merchant banker. It is complex and technical and assessing authorities does not possess such expertise [sic]."

Why is this important for other startups?

The ruling can help startups who are challenging these tax demands.

Section 56(2)(viib) of the I-T Act was introduced to discourage promoters from routing their unaccounted money through third parties into the company at artificial premium. The section was aimed at taxing such a premium in the hands of the recipient company, said Manuj Sabharwal, Advocate on Record, Supreme Court.

These instances are hard to detect but many startups, which often report losses and raise capital at valuations based on future potential, became soft unintended targets of this provision, said Sabharwal, a tax and regulatory expert who was part of the team representing Oyo before the ITAT.

""Since a lot of startups began facing heat from this regulation, even though it was never meant to target them, they made representations before the finance ministry with their grievances and basis that this section was done away with in 2024," said Sabharwal.

The government, in July 2024 in its budget for the financial year 2024-25, scrapped the angel tax. The ITAT's order shows that the Oyo case, like several others, came from tax assessment which was initiated before 2024.

Published by HT Digital Content Services with permission from VC Circle.