India’s Ministry of Finance on September 25 notified new angel tax rules that provide more leeway in estimating the valuation of startups receiving investments.
The rules retain all the five new valuation methods proposed in the draft rules released earlier in May, provide a new valuation method for compulsorily convertible preference shares (a popular investment instrument), allow a buffer for valuation discrepancies, and bring parity to resident and non-resident investors.
What is angel tax: Introduced in 2012 to prevent tax avoidance and money laundering, the angel tax refers to section 56(2)(viib) of the Income Tax Act, 1961, which requires an unlisted startup to pay tax (of about 30 percent) on any investment it receives by issuing shares to investors at a price higher than the fair market value (FMV) of those shares. This premium is considered as income for the startup. Earlier, the angel tax was only applicable to investments made by Indian residents, but it was extended to non-resident investors as part of the Finance Act 2023. Startups registered with the Department for Promotion of Industry and Internal Trade (DPIIT) have been exempted from the angel tax since 2019.
Why does this matter: Startups have criticised the angel tax because estimating the fair market value based on the allowed valuation methods was highly restrictive and could result in an excessive tax burden on startups or deter investors from funding startups. The new rules could hopefully offer some relief as it provides more leeway in the estimation of fair market value, thus possibly reducing the tax burden of startups raising money or even helping them avoid it altogether.
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Key features of the new rules
The Finance Ministry outlined the following key features of the new angel tax rules in a press release:
1. Five new valuation methods available for non-resident investors: Earlier, there were two methods of estimating the fair market value of share: Discounted Cash Flow (DCF) and Net Asset Value (NAV). In addition to these methods, five more valuation methods have been made available for non-resident investors:
- Comparable Company Multiple Method
- Probability Weighted Expected Return Method
- Option Pricing Method
- Milestone Analysis Method
- Replacement Cost Method.
2. Price matching for resident and non-resident investors: If a startup receives investment by issuing shares to a non-resident entity notified by the central government, the price of the equity shares corresponding to such investment may be taken as the fair market value of the equity shares for both resident and non-resident investors, subject to the following:
- The investment does not exceed the aggregate investment that is received from the notified entity, and
- The investment has been received by the company from the notified entity within a period of 90 days before or after the date of issue of shares.
Similarly, price matching for resident and non-resident investors would be available with reference to investment by Venture Capital Funds or Specified Funds.
3. Valuation method for CCPS: The new rules also provide valuation methods for calculating the fair market value of Compulsorily Convertible Preference Shares (CCPS), which are a type of financial instrument that is issued by startups to raise capital and are popular among venture capital funds that invest in India.
4. Ten percent buffer: The rules provide a safe harbour of 10% for any discrepancies in valuation.
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