Income tax department notifies 'angel tax' rules for valuing startups

The income tax department has notified rules for valuation of equity and compulsorily convertible preferable shares issued by startups to resident and non-resident investors.

As per the changes in Rule 11UA of I-T rules, which came into effect on September 25, the Central Board of Direct Taxes (CBDT) provides that the valuation of compulsorily convertible preference shares (CCPS) can also be based on the fair market value of unquoted equity shares.

The amended rules retain the five new valuation methods proposed in the draft rules for consideration received from the non-residents viz., (i) Comparable Company Multiple Method, (ii) Probability Weighted Expected Return Method, (iii) Option Pricing Method, (iv) Milestone Analysis Method, and (v) Replacement Cost Method.

Nangia & Co LLP Partner Amit Agarwal 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 benefitting both taxpayers and the government.

"These changes offer taxpayers a broader range of valuation methods to choose from, including internationally recognised approaches, thereby attracting foreign investments and fostering clarity. Moreover, the notified final rule introduces an additional sub-clause specifically addressing CCPS," said Agarwal.

AKM Global Tax Partner Amit Maheshwari said the new angel tax rules have very well taken care of an important aspect of CCPS valuation mechanism, which was not the case earlier since most of the investments in India by VC funds is through the CCPS route only.

"The extension of 10% 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," said Maheshwari.

The CBDT had, in May, come out with draft rules on valuation of funding in unlisted and unrecognised startups for levying income tax, commonly termed as 'angel tax', and had invited public comments on it.

The amended rules are aimed at bridging the gap between the rules outlined in FEMA (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. This was commonly referred to as angel tax.

The Finance Act, 2023 has said that such investments over and above the fair market value will be taxed irrespective of whether the investor is a resident or non-resident.

Post the amendments in the Finance Act, concerns have been raised over the methodology of calculation of fair market value under two different laws.