Angel Tax: Experts say most startups unlikely to benefit from new rules

Tax experts have sought clarity on draft rules for foreign investment in unlisted startups as the proposed norms mention only equity shares, skipping out on instruments such as compulsorily convertible preference shares used by startups to raise funds.

Under the existing norms, only investments by domestic investors or residents in closely held companies were taxed over and above the fair market value. However, the Finance Act, 2023, amended Section 56 (2) (viib) of the Income Tax Act, popularly known as the 'angel tax' provision, to bring within its ambit foreign investments as well. Startups recognised by the Department for Promotion of Industry and Internal Trade (DPIIT) are exempted from the 'angel tax'.

"It is pertinent to note that the prescribed valuation methods are applicable only for unquoted equity shares, whereas it is common for foreign investors to invest in convertible instruments such as convertible preference shares," says Shruti K.P, partner, IndusLaw.

"The proposed draft rules are silent on the valuation methodologies to be adopted for such instruments. Accordingly, valuation methods for convertible instruments should also be clarified and an amendment to this effect should be made in the final version Rules," she adds.

Angel tax applies when a closely held company issues shares at a premium and receives consideration that is in excess of the fair market value of the shares. The excess amount so received is deemed as income from other sources in the hands of the company.

"The new income-tax valuation rules that will apply to Indian start-ups that raise capital from non-resident investors, do not provide much relief to Indian startups as a whole," says Russell Gaitonde, partner, Deloitte India.

"This is because the safe harbour has been provided only to select Indian start-ups that satisfy certain prescribed conditions. For example: (i) the start-up should have been registered with the Department for Promotion of Industry and Internal Trade, (ii) it should be of a small size and scale, i.e. having a share capital and share premium not exceeding ₹25 crore and a turnover not exceeding ₹100 crore, (iii) it should not have invested in specific assets, including any share/securities or capital of any other entity, etc. Only a small universe of Indian startups would be able to satisfy the aforesaid conditions, and hence stand to benefit from the recent tax notification issued by the CBDT," says Gaitonde.

However, the larger universe of Indian entities, such as startups that do not satisfy these conditions, or new-age companies, or companies raising growth capital, are unlikely to benefit from the recent tax notification, Gaitonde adds.

The Central Board of Direct Taxes last week notified that non-resident investments into private Indian startups from 21 countries, including countries like the U.S., the U.K., Germany, and France, will not attract angel tax. The Netherlands, Singapore, and Mauritius, however, have been kept out of the list even though many were one of the biggest contributors of foreign direct investment (FDI) to India.

As per the CBDT notification, a tolerance limit of 10% shall be introduced to factor in variations due to forex fluctuations, bidding processes and other economic indicators, etc. which may affect the valuation of the unquoted equity shares during multiple rounds of investment.

Start-ups not registered with DPIIT, and those investments not falling under the specific exemptions, would still have to bear the brunt of the angel tax, says Shruti.

"A key concern that companies will continue to have is, whether the tax office will have unbridled powers to continue to question the valuations, which is currently the case. Given that the new valuation methodologies include methods such as the comparable company multiple method, disagreement with the tax department on identification of correct comparables cannot be ruled out, leading to questioning of the valuation reports," Shruti explains.

Further, the new rules will also create an additional burden of obtaining a separate valuation report for foreign investment, which could dampen the spirit of foreign investors and impact the ease of doing business in India, she adds.

According to Bhavin Shah, deals leader at PwC India, "Almost all fresh investments by VC Funds in startups has historically been through compulsorily convertible preference shares. The relaxation provided under draft rules for price matching and 10% safe harbour is restricted to equity shares.

"It is important that these relaxations are extended to investments by way of CCPS as well," says Shah.

The CBDT has invited comments from stakeholders as well as the general public on rules for valuing non-resident investment in unlisted startups by June 5.

Rule 11UA currently prescribes two valuation methods with respect to the valuation of shares: the discounted cash flow (DCF) and net asset value (NAV) methods for resident investors. The new draft rule proposes to insert five additional valuation methods specifically for non-resident investors.

"The draft rules set out two sets of valuation norms relevant to angel tax for share issuance to residents and non-residents. For issuances to residents, NAV method or the DCF method remain applicable. For issuances to non-residents, in addition to such valuation norms applicable to residents, some other valuation methodologies have been prescribed such as milestone analysis method, replacement cost method, etc. However, common market practice thus far has been to use the DCF method of valuation," says Gouri Puri, partner, Shardul Amarchand Mangaldas & Co.

The government has also notified classes of investors, which will not come under the provisions of 'angel tax'. These are entities registered with the Securities and Exchange Board of India as Category-I Foreign Portfolio Investors; endowment funds associated with a university, hospitals, or charities; pension funds created or established under the law of the foreign country or specified territory; and broad-based pooled investment vehicle or fund where the number of investors in such vehicle or fund is more than fifty and such fund is not a hedge fund or a fund which employs diverse or complex trading strategies.

The main tweak for both issuances to residents and non-residents, is that VCU's (Venture Capital Undertaking) can use the share price at which they issue shares to VCFs (Venture Capital Funds) and Category I and Category II AIFs to benchmark for fair market value for issuances to other investors, subject to certain conditions, says Puri. "Similarly companies can use the share price at which they issue shares to the recently notified investors to benchmark for fair market value for issuances to other investors, subject to certain conditions. Having such a notified investor on-board in a funding round may be of more value to justify the issue price offered across investors (coming in at same or lower price)," says Puri.