Angel tax for start-ups: What CBDT has clarified after scrutiny notices

What is the new tax directive on start-ups?

Citing issuance of scrutiny notices to start-up companies under the CASS (Computer-Assisted Scrutiny Selection), the CBDT in its directive has stated that procedure has been laid out for the assessment of such startup companies, which have been recognized by the DPIIT and no verification is required for such start-ups for notices related to the amended provisions for angel tax.

This clarification by the tax department comes after many startups had raised concerns about receiving scrutiny notices for angel tax.

The CBDT has outlined two scenarios: firstly, where the case of such start-up company is selected under scrutiny on the single issue of applicability of section 56 (2) (viib) of the Income-tax Act, no verification on such issues shall be done by the Assessing Officers during the proceedings u/s 143 (2) or u/s 147/143(2) of the Act and contention of such recognized start-up companies on the issue will be summarily accepted.

Secondly, where the case of such start-up company is selected under scrutiny with multiple issues including the issue under section 56 (2) (viib) of the I-T Act, the issue of applicability of section 56 (2)(viib) of the Act “shall not be pursued during the assessment proceedings of such startup company”.

What is angel tax for start-ups ?

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.

What were the changes for angel tax in Budget 2023-24?

The Finance Act, 2023, had amended Section 56(2)(viib) of the Income-tax Act. The provision, colloquially known as the ‘angel tax’ was first introduced in 2012 to deter the generation and use of unaccounted money through the subscription of shares of a closely held company at a value that is higher than the fair market value of the firm’s shares.

The provision had stated that when an unlisted company, such as a start-up, receives equity investment from a resident for issue of shares that exceeds the face value of such shares, it will be counted as income for the start-up and be subject to income tax under the head ‘Income from other Sources’ for the relevant financial year. With the latest amendment, the government had proposed to also include foreign investors in the ambit, meaning that when a start-up raises funding from a foreign investor, that too will now be counted as income and be taxable. The DPIIT-recognised startups were excluded from the angel tax levy.

In September, the Finance Ministry notified final valuation rules for foreign and domestic investors into unlisted companies such as start-ups under the new angel tax mechanism. The rules had accounted for the industry’s calls by addressing an additional sub-clause of compulsorily convertible preference shares (CCPS), stating that the valuation of CCPS can also be based on the fair market value of unquoted equity shares.

Besides the discounted cash flow (DCF) method for resident investors, the tax department prescribed five valuation methods for non-resident investors: comparable company multiple method; probability weighted expected return method; option pricing method; milestone analysis method; and replacement cost method.

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.