Finance Ministry notifies angel tax valuation rules for investments in startups

As per the changes in Rule 11UA of Income Tax rules, which comes into effect from September 25, the Central Board of Direct Taxes (CBDT) has provided that the valuation of CCPS can also be based on the fair market value of unquoted equity shares.

Angel tax – which is income tax at the rate of 30.6 per cent – is levied when an unlisted company issues shares to an investor at a price higher than its fair market value. Earlier, it was imposed only on investments made by a resident investor. However the Finance Act 2023 proposed to extend angel tax even to non-resident investors from April 1, 2024.

Start-ups had raised concerns around the proposal given that it could have impacted foreign investments – a key source of their funding – and that it came at a time when a funding winter was setting in, making it already difficult for them to raise money.

The recent directive has also extended the 10 per cent safe harbour provision to convertible preference shares, a relief which was so far only restricted to equity shares. Almost all fresh investments by venture capitalists funds in startups have historically been through CCPS.

Besides the discounted cash flow (DCF) method for resident investors, the new rule prescribes five methods for non-resident investors. This includes comparable company multiple method; probability weighted expected return method; option pricing method; milestone analysis method; and replacement cost method.

Any deal made within 90 days of a previous equity fund infusion done by an investor exempt from Angel Tax rules can be done at the same fair market valuation as before.

“The amendments to Rule 11UA of the Indian Income Tax Act bring positive changes… These changes offer taxpayers a broader range of valuation methods to choose from, including internationally recognised approaches, thereby attracting foreign investments and fostering clarity,” said Amit Agarwal, Partner, Nangia & Co LLP.

Agarwal added that the changes offer taxpayers flexibility through multiple valuation methods, simplifying the valuation date consideration, incentivising venture capital investments, facilitating investments from notified entities, providing clarity on compulsorily convertible preference shares, and encouraging foreign investments.

The amended rules are aimed at bridging the gap between the rules outlined in the Foreign Exchange Management Act and the Income Tax Act. 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.

In May, the Finance Ministry had exempted investors from 21 countries including the US, UK and France from the levy of angel tax for non-resident investment in unlisted Indian start-ups. However, the list excluded investment from countries like Singapore, Netherlands and Mauritius – which have traditionally been key geographies for start-ups to raise money.