All you need to know about IT dept’s new ‘Angel Tax’ rule for valuing equities in startups

For valuing equity and compulsorily convertible preferred shares issued by startups to resident and non-resident investors, the Income Tax department has announced a “Angel Tax” rule. In accordance with the revisions to Rule 11UA of the I-T rules, which take effect on September 25, the Central Board of Direct Taxes (CBDT) mandates that the valuation of Compulsorily Convertible Preference Shares (CCPS) may also be based on the fair market value of unquoted equity shares.

The five new valuation techniques that were included in the draft regulations that were suggested by non-residents were also retained in the revised rules:

(i) Comparable Business Multiple Method

(ii) Method of Probability Weighted Expected Return

(iii) Option Pricing Method

(iv) Milestone Analysis Method

(v) The Replacement Cost Approach

Modifications to Rule 11UA

The amendments to Rule 11UA of the Indian Income Tax Act, according to Nangia & Co LLP Partner Amit Agarwal, result in positive changes by giving taxpayers flexibility through a variety of valuation methods, simplifying the valuation date consideration, encouraging venture capital investments, facilitating investments from notified entities, providing clarity on CCPS, and promoting foreign investments.

He added that adding a tolerance limit for slight valuation disparities would improve the accuracy and fairness of tax assessments overall, which would be advantageous to both taxpayers and the government. “These revisions give taxpayers access to a wider variety of valuation techniques, including widely accepted ones, luring foreign investment and promoting clarity. Additionally, the notified final regulation adds a new sub-clause that specifically mentions CCPS, according to Agarwal.

According to Amit Maheshwari, an AKM Global Tax Partner, the new “Angel Tax” regulations have very effectively addressed a crucial part of the CCPS valuation mechanism, which was not the case in the past given that the majority of investments made in India by VC funds are made only through the CCPS method.

Maheshwari continued, “The extending of 10% safe harbor to CCPS investments as it was before intended for equity shares will create a necessary margin of safety for dealing with foreign exchange volatility and is a positive measure. The CBDT released draft regulations—commonly known as the “Angel Tax”—on the value of funding in unlisted and unrecognized firms in May and solicited public feedback.

Goals of the New Rules

The revised regulations are intended to close the discrepancy between the Income Tax and the FEMA regulations. Only investments made by domestic investors or residents in privately owned businesses or unlisted corporations have thus far been subject to taxes beyond fair market value. An angel tax was the common name for this.

Notably, the Finance Act of 2023 stipulates that taxes on such investments beyond the FMV shall apply whether the investor is a resident or a non-resident. Concerns have been raised over the methods used to determine fair market value under two different regulations following changes to the Finance Act.

Conclusion:-

The Indian Income Tax department has announced a new “Angel Tax” rule for valuing equity and compulsorily convertible preferred shares issued by startups to both resident and non-resident investors. The revisions to Rule 11UA of the I-T rules, which take effect on September 25, mandate that the valuation of Compulsorily Convertible Preference Shares (CCPS) may also be based on the fair market value of unquoted equity shares. The five new valuation techniques included in the draft regulations were retained in the revised rules. The amendments aim to provide taxpayers with flexibility through various valuation methods, simplify valuation date consideration, encourage venture capital investments, facilitate investments from notified entities, provide clarity on CCPS, and promote foreign investments. They also aim to improve the accuracy and fairness of tax assessments, benefiting both taxpayers and the government. The revised regulations aim to close the discrepancy between the Income Tax and the FEMA regulations, which have previously subjected investments to taxes beyond fair market value.