Angel tax In India: Blessing in Disguise or Bane for start-ups?
Nov 27, 2023
What is Angel tax:
India has emerged as the 3rd largest ecosystem for start-ups globally along with India is now the 3rd largest economy in the Asia-Pacific region and the 5th largest in the world. Hence any change in regulations/laws directly or indirectly impacts the world.
Recently, the Income Tax Department has issued new angel tax regulations, including a system for assessing the shares that unlisted start-ups offer investors.
The Income Tax Act of 1961's Section 56 (2) (viib) discusses the concept of angel tax. According to the Finance Act, 2012, in the IT Act, every start-up (i.e., unlisted companies whose shares are not available for buying on the stock market) that receives funding from an angel investor must contribute a certain amount to the government.
However, this tax comes into the picture if the total investment value exceeds the company's FMV (Fair Market Value). If the raised funds are greater than FMV, then it will be categorised as income for the start-up and subject to income tax under the category of "income from other sources", and the tax imposed on it is called angel tax.
Let us consider it with an example. Suppose a start-up receives an investment from an angel investor of Rs 15 crore, and the investor gets shares in exchange. However, the total fair market valuation (FMV) of the shares issued is Rs 10 crore. The remaining Rs 5 crore is considered excess money and, therefore, taxable at a rate of 30.9%.
Changes in the previous tax regulation
Earlier, the angel tax applied to the funds raised by residents of India, however in the new regulation – the same is also applicable to foreign investors.The excess investment, by domestic and foreign investors, is considered as ‘income from other sources’ and the government levies an ‘Angel Tax’ on it since it primarily affects angel investors in start-ups.
Exceptions:
Type of Investors: Not all foreign investors are eligible for the angel tax. The exemptions have been provided to below listed classes of foreign investors:
a) Government-related investors, like central banks, sovereign wealth funds, and global or multilateral organisations or where ownership of the government is 75% or more.
b) banks or organisations in the insurance business;
c) Entities registered with SEBI Registered Category-I FPIs, specific categories of endowment and pension funds.
d) Broad-based pooled funds with 50 or more investors that are not a hedge fund or a fund that employs complex trading strategies.
e) Investors from 21 countries have been exempted: Australia, Singapore, Germany, Japan, Korea, the UK, and the US among others.
2. The government-recognized start-up: Foreign investors are not required to pay any angel tax while investing in a government-recognized (Department for Promotion of Industry and Internal Trade - DPIIT registered) start-up in India.
All that a start-up needs to do is apply for eligibility to DPIIT along with necessary documents and returns which will then be sent to CBDT (Central Board of Direct Taxes) for final approval. The CBDT reserves the right to decline the exemption status for a company.
Now, according to the revised rules, the companies need to meet certain requirements to be eligible for the exemption-
As per earlier rules, the exemption from angel tax was for companies with turnover up to Rs 25 crores, but as per new rules, the exemption limit has been extended to companies with turnover less than Rs 100 crores and those companies should be less than 10 years old.
If the aggregate amount of paid-up share capital and share premium of the firm after the issue or proposed issue of shares doesn't exceed Rs 25 crore. This means that small-scale angel investors who invest under Rs 25 crore in start-ups are exempted from the tax.
Further, investments made by listed companies with a net worth of at least ₹100 crore or a total turnover of at least ₹250 crore will be fully exempt from the tax; so will investments made by non-resident Indians.
Also announced that start-ups will not be required to present the fair market value of their shares issued to certain investors including Category-I Alternative Investment Funds (AIF).
Changes in the valuation Methodology: Now, the next question arises how is this tax calculated?
Earlier, CBDT prescribed the below-mentioned methodologies for the valuation of equity shares and preference shares under Rule 11 UA of the Income Tax Rules 1962 for the issuance of shares to Resident investors:
For Equity Shares: Discounted free cash flow method and Adjusted Book Value method and
For Preference Shares:Any internationally accepted valuation method
However, recently, The CBDT notified amendments to Rule 11 UA of the Income Tax Rules 1962, for the valuation of the equity shares and compulsorily convertible preference shares (“CCPS”) for angel tax provisions with effect from 25th September 2023.
a) Adjusted Book Value Method: This method retains its previous formula without any changes.
b) DCF Method: Under this approach, fair value is calculated using the Discounted Cash Flow (DCF) method, with a valuation report obtained from a Merchant Banker. This is also similar to the earlier formula without any changes. However in the case of preference shares earlier, the valuation using the DCF method could also have been carried out by a Chartered Accountant. As per the amended rules, valuation can only be carried out by a Merchant Banker.
c) Venture Capital Scenario: Shares may be valued at the same price at which a Venture Capital Undertaking raised funds from a Venture Capital Fund, Venture Capital Company (VC), or an Alternative Investment Fund (AIF), provided the total consideration received from the new investor does not exceed the total consideration received from VC/AIF.
A maximum gap of 90 days is allowed between the valuation of shares and their issuance to such VC or AIF.
d) Comparable Company Multiple, Probability-Weighted Expected Return, Option Pricing, Milestone Analysis, or Replacement Cost Method: Valuation under this method is conducted based on a report from a Merchant Banker. These methods are internationally accepted valuation methodologies and are widely used.
e) Notified Entity Scenario: Shares can be valued at the same price at which the company received funds from a notified entity. Similar to method (C), a maximum gap of 90 days is permissible between the valuation and issuance to such notified entity.
Fair Market Value of Unquoted Equity Shares
Consideration received from Resident - Method (a), (b),(c), & (e)is used to determine the value at the option of assesses.
Consideration received from Non-Resident - Method (a) to (e) is used to determine the value at the option of the assessee. When a company receives any consideration for the issue of shares from a non-resident entity notified by the Centre, the price of the equity shares corresponding to such consideration may be taken as the (FMV of the equity shares for resident and non-resident investors. On similar lines, price matching for resident and non-resident investors will be available concerning investment by venture capital funds or specified funds.
Fair Market Value of Convertible Preference Shares (CCPS):
a) Method (b), (c), & (e) of the above-listed methods is available at the option of the assessee or based on FMV of equity share determined based on Method (a), (b), (c), & (e) at the option of assesses where the consideration received from Resident.
b) Method (b) to (e) of the above-mentioned methods is available at the option of the assessee or based on FMV of equity share determined based on Method (a) to (e) at the option of the assessee where the consideration received from non-Resident.
‘Safe harbour’ provision - Threshold of 10%
For CCPS or Unquoted Equity Shares, where the issue price of the shares exceeds the value of shares as determined by:
Method (a) or Method (b), for consideration received from a resident, by an amount not exceeding 10% of the valuation price, the issue price will be FMV of such shares.
Method (a) Method (b) or Method (d), for consideration received from a non-resident, by an amount not exceeding 10% of the valuation price, the issue price will be FMV of such shares.
Role of the Assessing Officer (AO)
56(2)(viib) clearly states that the FMV shall be the higher of:
a) Value as per NAV or DCF (Rule 11UA(2))
OR
b) Value to the satisfaction of the AO based on the value of the company as of the date of issue of shares
It is clear from the first reading that in case the AO is unsatisfied with the assumptions used to compute the valuation or believes the value to be lower, the disjunctive OR allows for the higher value to be the Fair Market Value (FMV).
Ideally, the Assessing Officer should not have the discretionary power to disregard a valuation acceptable to the entrepreneurs and a group of sophisticated investors and arrived at by a professional in the form of a qualified Chartered Accountant or a Category I Merchant Banker. Many start-ups have faced a challenge whereby the AO takes the lower value as the FMV and taxes the entire premium as income in the hands of the companies. This results in the law not being fully enforced, leading to consistent bias against the companies. Do you know, that in 2018, more than 2000 start-ups received a legal tax order via MCA against the share premiums?
Pros:
a) Inclusion of more methods of valuation to give flexibility to the assessee and the Valuers
b) A safe harbour of 10% variation in valuation price and issue price is acceptable.
c) Earlier the valuation rules required the valuations to be carried out on the date of the transaction which was practically impossible to comply with. However, as per new regulation, the valuation date for issuance of the report can be considered up to 90 days, before the issuance of shares, which is in line with the requirement of FEMA Regulations
d) In the case of investment by venture capitalists, the price negotiated by venture capital investors may be considered an acceptable price. This is the significant positive step where the transaction involves registered / sophisticated investors negotiating price acts as the base of valuation.
Cons:
- Funds received from non-residents may be subject to tax in case valuation is rejected by the Assessing officer and big negative for the investor community.
- Increased compliance burden and risk on amounts received from non-residents.
- Not in line with Government policy for ease of doing business
- Multiple valuers and multiple reports for the same transaction as different laws recognise different valuers, ie. Companies Act recognises only Registered Valuers as Valuers and Income Tax recognises only Merchant Bankers as Valuers.
- Different requirements for resident and non-resident investors and thus increasing complexity of regulations
Conclusion:
It is worth noting that out of the $10 Bn of investment into the Indian start-up ecosystem in 2022, only 10% of it came from domestic investors. The recent regulations raise a question about the viability of the inspirational start-up initiatives launched by the company such as Make in India and Start-up India. Hence, the regulations or laws levied by the government should be conducive to the start-up ecosystem.
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