Tax department notifies 'Angel Tax' rules for valuing investments in startups

The Income Tax Department has notified new angel tax rules that comprise a mechanism to evaluate the shares issued by unlisted startups to investors. While previously the angel tax - a tax levied on capital received on the sale of shares of a startup above the fair market value - applied only to local investors, the Budget for 2023-24 fiscal (April 2023 to March 2024) widened its ambit to include foreign investments.

As per the Budget, the excess premium will be considered as 'income from sources' and taxed at the rate of up to over 30 per cent. However, startups registered by the DPIIT are exempt from the new norms.

The Central Board of Direct Taxes (CBDT) in a September 25 notification spelled out the valuation methodology. As per the changes in Rule 11UA of I-T rules, the Central Board of Direct Taxes (CBDT) provides that the valuation of compulsorily convertible preference shares (CCPS) and equity shares issued by unlisted startups can be based on the fair market value.

The amended rules also retain the five new valuation methods proposed in the draft rules for consideration received from the non-residents -- (i) Comparable Company Multiple Method, (ii) Probability Weighted Expected Return Method, (iii) Option Pricing Method, (iv) Milestone Analysis Method, and (v) Replacement Cost Method. Deloitte India Partner Sumit Singhania said from an investors' standpoint, revised rules offer a wider range of valuation methodologies to work with, and that ought to make compliance less onerous henceforth.

"Also, safe harbour permitting 10 per cent deviation from fair value makes room for valuation adjustments when needed. Overall, the trajectory is to align tax valuation methodologies with permissible exchange control norms," Singhania said.

Nangia & Co LLP Partner Amit Agarwal said the amendments to Rule 11UA of the Indian Income Tax Act bring positive changes by offering taxpayers flexibility through multiple valuation methods, simplifying the valuation date consideration, incentivising venture capital investments, facilitating investments from notified entities, providing clarity on CCPS and encouraging foreign investments.

"The inclusion of a tolerance threshold for minor valuation discrepancies further enhances efficiency and fairness in tax assessments, ultimately benefiting both taxpayers and the government."

These changes offer taxpayers a broader range of valuation methods to choose from, including internationally recognised approaches, thereby attracting foreign investments and fostering clarity.

Moreover, the notified final rule introduces an additional sub-clause specifically addressing CCPS," Agarwal said.

SW India Managing Partner and Co-founder Atul Puri said the CBDT has amended Rule 11UA to arrive at the fair market value of unquoted shares issued to resident and non-resident investors.

Rule 11UA at present prescribes two methods for the valuation of unquoted shares -- DCF (Discounted Cash Flow) method and NAV (Net Asset Value) method for resident investors.

However, there was no specific reference to the valuation of shares issued to non-resident investors, and this would lead to confusion and litigation between tax officers and non-resident investors.

Amended Rule 11UA includes five more valuation methods available as an option to non-resident investors, in addition to DCF and NAV methods. However, the option to value equity shares as per any of these five methods is not available to resident investors.

"The amended Rule 11UA is a welcome move, which brings in more clarity for both investor and investee, basis which an appropriate valuation method can be adopted, thereby reducing the chances of any future litigation and addressing illegitimate or non-genuine transactions while promoting investments in eligible startups," Puri said.

AKM Global Tax Partner Amit Maheshwari said the new angel tax rules have very well taken care of an important aspect of the CCPS valuation mechanism, which was not the case earlier since most of the investments in India by VC funds are through the CCPS route only.

"The extension of 10 per cent safe harbour to CCPS investments as it was earlier meant for equity shares will give a necessary margin of safety for taking care of foreign exchange fluctuations and is a welcome move," Maheshwari added.

The CBDT had in May come out with draft rules on the valuation of funding in unlisted and unrecognised startups for levying income tax, commonly termed as 'Angel Tax' and had invited public comments on it.

The amended rules are aimed at bridging the gap between the rules outlined in FEMA and the income tax. So far, only investments by domestic investors or residents in closely held companies or unlisted firms were taxed over and above the fair market value.

This was commonly referred to as an angel tax. The Finance Act, 2023, has said that such investments over and above the FMV will be taxed irrespective of whether the investor is a resident or non-resident.

Post the amendments in the Finance Act, concerns have been raised over the methodology of calculation of fair market value under two different laws.

IndusLaw Partner Shruti K P said a tolerance limit of 10 per cent of the valuation price has also been allowed for both equity and CCPS issuances.

"Clarity on valuation norms for CCPS was long overdue and is indeed a welcome move, which may alleviate concerns on tax implications of CCPS issuances, especially to foreign investors," Shruti said.