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The latest amendments to the angel tax rules provide a certain degree of relief as they bring a sort of closure to the ambiguity surrounding angel investments by foreign and domestic investors. But there is much left unresolved.
“Innovation always outpaces the tax law, but with time the latter eventually catches up.” Entrepreneurs faced with India’s latest rules governing angel tax will relate to this old adage.
Last week, the country’s income tax (I-T) department finalised a set of rules that stipulate the payment of a 30% tax when a startup (or any unlisted private company) raises angel funding at a valuation above its fair market value (FMV). The new rules also introduced multiple new methodologies for the valuation of startups.
In effect, when a startup issues shares to angel investors at a price higher than its FMV, the mark up in share price is treated as “income from other sources” and is taxable, regardless of whether or not the startup is profitable.
While the latest amendments provide a certain degree of relief as they bring a sort of closure to the ambiguity surrounding angel investments by foreign and domestic investors, there is much left unresolved. Introduced in 2012, the angel tax -- or section 56(2)(viib) of the Income Tax Act -- has been a cause of heartburn among startup founders as angel funding is vital oxygen for nascent startups.
What changed in April-May 2023
Prior to April 2023, angel tax was restricted to investments raised by private unlisted companies from resident investors. However, in the Finance Act 2023, the government decided to expand the scope to include non-resident investors. In May 2023, the Central Board of Direct Taxes (CBDT) proposed amendments to Rule 11UA of the Income Tax Rules, 1962, for computation of FMV of unquoted equity shares for section 56(2) (viib) of the Income Tax Act (“Rule 11 UA Amendments”).
This caused significant concern as foreign funding is a key capital raising avenue for startups.
The CBDT also issued two more notifications – No. 29 and No. 30 – which mentioned entities that were exempt from the angel tax.
Some key changes proposed via Rule 11UA Amendments and Notifications 29 and 30 were as follow:
1. More valuation methods: The addition of five more methods for fair valuation of equity shares to be determined by a merchant banker, in addition to the existing sole method of Discounted Cash Flow Valuation (DCF). This was possibly done to soften the blow to non-resident investors and provide flexibility for application of alternative valuation methods.
2. FMV benchmarking: Any investment by venture capital funds or specified funds or certain notified investors (“Notified Investors”) was to serve as an FMV benchmark (original funding). Two conditions were to be met for FMV benchmarking. One, FMV benchmarking was restricted to the amount financed by notified investors i.e. it would be available to the extent any subsequent financing raised by the company matched the original funding by the notified investors; and, two, the subsequent financing had to be closed in 9o days, after which the FMV benchmarking benefit would fall off.
3. Safe harbour: The safe harbour rule for price variations up to 10% from the FMV of equity shares on account of factors such as forex fluctuations, bidding processes, other economic indicators, etc. for resident and non-resident investors.
4. Allowing valuation reports issued up to 90 days before the date of issue of equity shares for computing the FMV of the equity shares. The valuation date could be deemed to be the date of the report at the option of the assessee.
5. Exemptions: Three categories would be exempted from the ambit of angel tax provisions: Government and government-related investors; banks or regulated entities involved in insurance business; and Securities and Exchange Board of India (SEBI) registered Category-I foreign portfolio investors, endowment funds, pension funds and broad-based pooled investment vehicles or funds with more than 50 investors residing/regulated/incorporated in listed 21 jurisdictions.
6. Exemption criteria: Startups were exempted from the angel tax provision if they fulfilled the conditions specified by the Department for Promotion of Industries and Internal Trade (DIPP). These include (i) Recognition by DIPP as a startup; (ii) The aggregate of the paid-up share capital and share premium of the startup should not exceed, Rs 25 crore (excluding shares issued to a non-resident/or VC fund); (iii) No investment was to be made in certain assets for a period of around seven years after shares are issued at a premium. These assets include building or land; loans and advances; capital contribution made to any other entity; shares and securities; a motor vehicle, aircraft, yacht or any other mode of transport costing above Rs. 10 lakhs except where used in ordinary course of business (eg: plying, hiring leasing or as stock-in-trade); jewelry other than that held by the startup as stock-in-trade in the ordinary course of business.
However, the changes proposed in May 2023 had certain shortcomings, as detailed below:
1. The FMV computation for the issue of unquoted shares other than equity shares i.e. instruments other than equity shares (e.g. convertible/non-convertible /preference shares, debentures), which are customary instruments for fundraising were not covered by these draft rules.
2. The list of exempted countries excluded some key jurisdictions like Singapore, UAE, Mauritius, the Netherlands and Luxembourg – all of which contribute significantly to India’s FDI in terms of quantum of investment. Further, only certain categories of investors in exempt countries had been provided with the relaxation.
3. It was not clear if the new or additional methods of valuation were applicable to resident investors as well.
4. It may have been better to consider a 90-day window from the valuation date and not the date of the report.
5. Mis-alignment between FEMA/Companies Act 2013 and income tax regulations pertaining to valuation and reporting requirements continues to be a challenge.
6. Lack of commercial flexibility in the rules affects the ability to build in valuation adjustments, value multiples and discounts in investment transactions, often required in early-stage businesses. Rights and provisions customary to venture and private equity investments such as anti-dilution adjustments, conversion formula arrangements, liquidation preference waterfalls and performance/milestone-based valuation adjustments for startups remain a practical concern.
7. The definition of a startup and the conditions prescribed under DIPP notification dated February and March 2019 (as stated above) remained impractical.
What got clarified in September 2023
The September 25, 2023, notification and the amendments proposed are good but don’t go far enough. The amendments in brief are:
A few difficulties remain unresolved in the September 2023 notification, as follows:
In times such as the present, when startup funding is difficult to come by, the focus should be on ease of compliance and harmony across regulators rather than prescribing more mechanisms to justify unnecessary amendments. Angel tax in itself is a painful regulation and to have such magnitude of amendments and clarifications over the years has left the startups having to focus on tax pitfalls rather than focussing on raising funds for their businesses.
This article was first published in DealstreetAsia.
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