Income Tax Department Issues ‘Angel Tax’ Rules For Valuing Investments In Start-ups

Under the new rules, the CBDT stated that the valuation of compulsorily convertible preference shares (CCPS) can also be decided on the fair market value of unquoted equity shares.

Experts noted that the revised rules consider a crucial aspect of the CCPS valuation mechanism, which was not kept in mind earlier as the majority of the investments in India by VC funds happen through the CCPS route.

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The income tax department issued norms regarding the valuation of equity and compulsorily convertible preferable shares issued by start-ups to resident and non-resident investors. The revised norms are effective from September 25, the government said.

According to the changes in Rule 11UA of the I-T rules, the Central Board of Direct Taxes (CBDT) stated that the valuation of compulsorily convertible preference shares (CCPS) can also be decided on the fair market value of unquoted equity shares. The revised norms also retain the five new valuation methods suggested in the draft rules for consideration received from the non-resident investors, reported PTI. These five rules are comparable company multiple method, probability weighted expected return method, option pricing method, milestone analysis method, and replacement cost method.

Explaining the changes, Amit Agarwal, partner at Nangia & Co LLP, said, “The amendments to Rule 11UA of the Indian Income Tax Act bring positive changes by offering taxpayers flexibility through multiple valuation methods, simplifying the valuation date consideration, incentivising venture capital investments, facilitating investments from notified entities, providing clarity on CCPS and encouraging foreign investments. The inclusion of a tolerance threshold for minor valuation discrepancies further enhances efficiency and fairness in tax assessments, ultimately benefiting both taxpayers and the government. These changes offer taxpayers a broader range of valuation methods to choose from, including internationally recognized approaches, thereby attracting foreign investments and fostering clarity. Moreover, the notified final rule introduces an additional sub-clause specifically addressing CCPS.”

AKM Global Tax partner, Amit Maheswari, also noted that the new angel tax rules consider a crucial aspect of the CCPS valuation mechanism, which was not kept in mind earlier as the majority of the investments in India by VC funds happen through the CCPS route. He said, “The extension of 10 per cent safe harbour to CCPS investments as it was earlier meant for equity shares will give necessary margin of safety for taking care of foreign exchange fluctuations and is a welcome move.”

Earlier in May, the CBDT announced a draft of rules on the valuation of funding in unlisted and unrecognised start-ups. These rules suggested levying income tax on this valuation, commonly known as ‘Angel Tax’ and the body asked for public comments on the same. The revised norms aim to narrow the gap between the rules mentioned in FEMA and the Income Tax.

Notably, till now, only investments made by domestic investors or residents in unlisted companies were taxed at a higher rate than the fair market value. This was termed an angel tax. However, the Finance Act, of 2023, noted that these investments above the fair market value would be taxed, whether they are made by domestic or resident investors or non-resident investors.