Angel Tax Rules: Some Clarity But Not Complete Clarity

 “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:

• Valuation methods for calculating the FMV of Compulsorily Convertible Preference Shares (CCPS) have now been incorporated. Earlier only equity shares were covered and therefore this is a relief for both resident and non-resident investors.
• In addition to Discounted Cash Flow (DCF) and Net Asset Value (NAV) methods five more valuation methods have been made available for non-resident investors, namely, Comparable Company Multiple Method, Probability Weighted Expected Return Method, Option Pricing Method, Milestone Analysis Method, Replacement Cost Method.
• 10 % safe harbour provision now extends to equity and CCPS and is applicable to non residents and residents alike.
• The final rules have further relaxed the FMV matching benefit (explained earlier in this article)  by providing a 90-day window before and after the date of  the Original Funding by Notified Investors.  Therefore, a Company can use the FMV in such a transaction as a benchmark without a separate valuation report for any funding 90 days before and after the Original Funding but limited to the extent of the Original Funding raised from the Notified Investors. 

A few difficulties remain unresolved in the September 2023 notification, as follows:

• The valuation misalignment between FEMA, Companies Act and Income tax remains a concern. The burden of compliance and multiple valuation reports under the Companies Act, Income Tax Act and FEMA make this impractical for startups. 
• No conditions or rules have been prescribed for instruments other than CCPS and Equity Shares. Other classes of convertible instruments (Convertible Debentures, Convertible Notes, Optionally convertible Preference Shares etc.) are not covered, although these are commonly used by resident and non resident investors.  
• Section 56(2)(viib) of the IT Act is applicable to the consideration received from non-residents on or after 1 April 2023 whereas the amended Rules are made applicable from 25 September, 2023, which will lead to confusion. 
• The conditions specified in paragraph 4 of the notification number  G.S.R. 127(E), dated the 19th February, 2019, issued by DIPP  for Angel Tax exemption remain startup-unfriendly and no relaxation was seen to any of these by either the CBDT or the DIPP in conjunction. Startups therefore have not significantly benefited from this angel tax exemption.  Out of the 99,380 DIPP startups recognised to date only 1,167 have income tax exemptions, leading to tax litigation. The final decision of whether to grant the exemption or not also rests with the CBDT, making this subjective.
• The list of exempted countries in the past notifications have not been amended (leading to continued exclusion of some key jurisdictions, as stated earlier).
• The pricing matching opportunity for establishing the FMV is very helpful as startups/companies can rely on the FMV by a Notified Investor for up to 90 days before and after. However, the condition around matching the quantum of funding with the original Funding i.e. limiting the benefit only to the extent of the funds infused by Notified Investors seems to be impractical and bizarre especially when large funding rounds are raised by companies at arm’s length and commitments are based on commercial considerations. This would expose any incremental investment beyond the Original Funding to tax litigation

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.